Understanding Student Loans 101

Laura Shin

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

  • Tony

    We were offered a Parent Plus Federal loan in my son award letter from the college he decided to attend. The rate on this loan is 7.9% and it has a 4% loan fee. The loans from the private institutions are half (for a fixed rate) and no fees. Is it still worth it to get the federal loan vs the private loan? Thanks.

  • Lauren

    Where do I go to obtain a college loan?