Understanding Student Loans 101

Understanding Student Loans 101

When you think of college, you may think of studying, spring break or late-night pizza in the dorm.

Or, you might be focused less on college itself and more on what it can do for your future career.

But what often comes as an afterthought is the price tag and how you’ll pay for it–which is bad, because college is expensive.

According to the College Board, the average cost of tuition and fees for the 2016–2017 school year was $33,480 at private colleges, $9,650 for state residents at public colleges, and $24,930 for out-of-state residents attending public universities. These figures don't include average room and board expenses, which can push costs up by more than $10,000 per school year.

Fortunately, you don't need to pay your tuition before attending your first lecture. Because education is considered good not just for you, but for society, many organizations offer scholarships and grants to help students pay for college. You should try to get as much of this free money as you can, but it probably won't be enough to cover all your costs. You'll likely have to take out student loans to cover the rest. Read on to find out what student loans are about, how they work and how you should handle them.

RELATED: 12 Key Terms to Know About College Financial Aid

Student Loans in a Nutshell

Student loans are similar to other loans in that you borrow money from a lender and promise that you'll repay it, with interest. But the terms of student loans differ in one key respect. In other loans, the borrower is expected to begin paying the loan off in installments as soon as the money is distributed. In the case of a student loan, which is made to someone not earning money full-time, the borrower/student is usually not expected to begin repaying the loan until after his/her education is over.

In the broad scheme of debt, student loans are also different from, say, credit card debt, because they are considered "good debt." While it’s never ideal to have debt, at least student loans tend to have low interest rates and represent an investment in your future. After all, a study by the Hamilton Project found that a $100,000 investment in college at age 18 yields a greater return than an equal investment in bonds or stocks. "Bad debt," such as credit card debt or a car loan, offers no such payoff.

While taking out a student loan for college should pay off, you should still be aware that you’re taking on debt. For that reason, be as careful about taking on this kind of debt as you would any other debt. As you’ll see shortly, some types of student loans are vastly superior to others.

Why It’s Important to Understand Student Loans

It's easy to have a relaxed attitude toward student loan debt since so many people accrue it. But today the burden of student loans is reaching such a crisis point that people question whether going into debt to earn a degree is financially worth it. For that reason, you should know the following when you take them on:

  • Student loan debt in the U.S. is at an all-time high of $1.2 trillion, outweighing credit card debt.
  • The Class of 2016 graduated with an average debt of $37,172, a record-breaking figure that exceeded the 2015 average by more than $2,000.
  • Over half of all graduates will delay buying a home because of their student loans, and approximately a quarter will delay having children.

But our goal here is not to scare you off college, which is a very worthwhile investment in terms of your life-long earning potential. Rather, we'll teach you the best way to take out student loans so they provide you with an important boost without weighing on you in the future.

How Student Loans Work

There are two broad categories of loans: federal and private. If you take anything away from this article, it should be that federal loans are much, much better than private loans. Your goal should be to get all the loans you need from the government. Only take out a private student loan as a last resort. The government caps how much it lends out to students, so if you turn to a private loan, do so only after you’ve gotten all you can in federal loans.

Federal Loans

Very broadly, this is how federal loans are granted: Before each school year begins, the government informs each school how much federal money it will receive to dispense to its students. The two main types of federal loans, Stafford and Perkins, are issued to students. A third, called a Direct PLUS loan, is made to a student’s parents. Each school is given a cap on the amount of money it can distribute for each type of loan.

When you apply to college, you’ll send the government a description of your family’s financial situation in something called the Free Application for Federal Student Aid (FAFSA). Using that, the government determines how much your family can be expected to contribute toward your education the next year and notifies the schools you’ve applied to of that amount.

Then the financial aid offices at those schools determine how much financial aid they’ll offer you and other potential students in scholarships, grants, Stafford loans, Perkins loans and/or Direct PLUS loans. The loans are awarded on a first-come, first-serve basis.

For your college education, the total amount you can take out in federal Stafford loans is $31,000 and the total limit for Perkins loans is $27,500, and there’s a limit on how much you can take out each year. Every year you are in school, you have to re-apply for financial aid, which means you'll repeat this process next year.

You’ll receive different loan packages from different schools for several reasons:

  • Costs at each school are different.
  • Each school will have a different amount it can offer in scholarships and grants.
  • Because of the first come, first serve policy, funds for, say, Stafford loans, may run out faster at one institution than another.
  • A school will sometimes sweeten the financial aid offer for a student it is particularly interested in.

RELATED: Negotiate Your Way to a Better Financial Aid Package

Why Federal Loans are Better than Private Loans

While the terms of each private loan will be different, private loans are generally worse than federal loans.

  • Private loans have variable interest rates, which means that the rate can change at any time, making it harder for you to budget and pay off the loan; interest rates on federal loans are fixed.
  • Private loans do not have special programs for unemployed or low-income borrowers or people who work in public service; federal loans do.

If You Have to Take Out a Private Loan

Each private loan has its own terms, so make sure you understand yours. Follow these guidelines so that it doesn’t become an undue financial burden:

  • Determine what your payment will be at the current interest rate and the maximum interest rate under the terms of your agreement.
  • Figure out whether, based on the projected salary you will be making after college and your expected expenses at that time, you could afford the maximum loan payment.
  • Find out what events would trigger a higher interest rate or extra fees: Missing a payment?
  • Ask what happens if you experience temporary financial hardship. Would they grant you a reprieve? Could you make smaller payments?
  • Before signing anything, talk with a financial aid officer at your school to see what they think of the loan’s terms.
  • Because lenders will be hesitant to loan money to you since you have a short credit history, you’ll likely need a co-signer—someone who signs onto the loan and promises to repay it if you fail to make payments. In most cases, co-signers on private loans are the student’s parents. Before signing, talk with your co-signer to make sure he/she is aware of all the terms of the loan.

Things to Keep in Mind

This is most likely the first time you'll be borrowing money, so use these guidelines to keep your debt burden to a minimum and do what’s best for your finances.

RELATED: 3 Things You Should Do Before You Pay Off Your Student Loans

1. Student loans are great, but grants and scholarships are better.
Grants and scholarships are free money … which means you don't need to pay them back. Grants are awarded mostly on a needs basis and can come from the federal or state government. Scholarships are awarded on need or merit by any number of sources, such as a nonprofit, or, if your grades are stellar, the school you're planning to attend. If you’re worried about the costs of college, try to get grants and scholarships to reduce the amount you have to take out in loans.

2. Decide whether an education at this university is worth the amount of debt you’ll have to take on.
When doing this calculation, take into account not just the loan but the amount you’ll pay in interest. So, for instance, if you take out the full amount in federal loans ($31,000) and pay it off over 10 years, you’ll also pay $11,800 in interest. Use this calculator to see how much your loan will cost you based on how quickly you pay it back. If you end up deciding it’s not worth it to take on that much debt, you could opt for a less expensive school, your parents could take out PLUS loans to help you, or you could decrease your college costs by spending a year or two at a community college to accumulate credits and then transfer to your school of choice for the remaining years.

3. Don't borrow more than you need.
Only borrow as much as you need for your tuition and living expenses while in college. If you’re not sure how much you’ll need, use our checklist.

4. Do your best to avoid a private loan.
Only pursue a private loan after you’ve gotten the maximum you could have gotten from the government. And if you decide you need to take one, make sure you understand its terms inside out.

Remember ...

Student loans are an important and worthy investment in your future, but taking out too much in loans or choosing loans from a private lender without looking into the fine print can quickly turn a good investment bad. If you do it right, however, the returns will make this debt entirely worth it.

RELATED: Out of School, Now What? 6 Things New Grads Should Do About Their Student Loans

This story was updated on February 16, 2017.

Update, October 31, 2012: We initially reported that private loans can charge fees but federal loans can't. However, federal loans do charge a processing fee.

Paul Sisolak of GoBankingRates.com contributed some reporting to this story. 

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