Student loans explained: How do they work?
Student loans let you borrow money for college costs and repay later with interest. You apply through FAFSA for federal loans or directly with lenders for private loans, funds go to your school, and payments usually start after you leave school. Federal loans come first for most families; private loans can fill gaps.
Navigating the world of financial aid can feel overwhelming, but understanding the mechanics of borrowing is the first step toward making confident decisions. This guide covers everything you need to know about the student loan lifecycle: the different types of loans available, the application process, how funds are disbursed to your school, the basics of interest accrual, and what to expect when repayment begins. By the end of this guide, you’ll understand how to apply for student loans, what happens to your loan funds, when repayment begins, and how to choose the right loan types for your situation.
Before diving into the specific programs available, it is essential to understand exactly what a student loan is and why it exists as a primary funding tool for higher education.
What are student loans and why do they exist?
At their core, student loans are funds borrowed specifically to pay for education-related expenses that must be repaid over time, usually with interest. Unlike grants and scholarships, which are “gift aid” and do not need to be paid back, loans are a financial obligation that requires careful planning. They exist to bridge the gap between what a family has saved or can afford to pay out-of-pocket and the total cost of attending college.
Student loans are versatile tools designed to cover more than just tuition. Acceptable educational expenses typically include mandatory fees, room and board (whether on-campus or off-campus), textbooks, supplies, equipment like computers, and even transportation costs. This flexibility ensures that students can focus on their studies without worrying about daily living expenses.
While taking on debt is a serious commitment, student loans are a mainstream and responsible way to invest in a future career. For many families, they are the key that unlocks access to higher education and the earning potential that comes with a degree. Rather than viewing loans solely as a burden, it is helpful to see them as an investment in human capital.
According to Sandy Baum, higher education finance expert, “Student loans can make the difference between whether or not students go to college, and that’s a good thing.” When used strategically and responsibly, these loans provide the necessary leverage to achieve academic and professional goals that might otherwise be out of reach.
Now that we’ve established what student loans are, let’s look at the two main categories: federal and private loans.
Federal vs private student loans: Key differences
The most critical distinction in student lending is between federal loans and private loans. Understanding the differences between these two sources is vital because it affects everything from your interest rate to your repayment options and legal protections.
Federal student loans are funded by the U.S. government. Their terms are set by law, meaning interest rates are fixed by Congress and do not depend on your credit score. They offer robust borrower protections, including flexible repayment plans based on income and potential for loan forgiveness. Because of these benefits, federal loans are almost always the best starting point for students.
Private student loans are offered by banks, credit unions, and online lenders. Unlike federal loans, eligibility and interest rates are based on the borrower’s (and often a cosigner’s) creditworthiness. While they offer less flexibility regarding repayment plans and forgiveness, they are a legitimate and necessary tool for filling funding gaps when federal limits are reached.
The following table outlines the major operational differences you need to know before applying:
| Feature | Federal Loans | Private Loans |
|---|---|---|
| Application | FAFSA required | Direct lender application |
| Credit check | Not required (except PLUS) | Required (cosigner often needed) |
| Interest rates | Fixed, set by Congress | Fixed or variable, credit-based |
| Repayment options | Multiple plans including income-driven | Varies by lender |
| Borrower protections | Deferment, forbearance, forgiveness programs | Limited, varies by lender |
Source: StudentAid.gov and College Finance research
To keep borrowing costs as low as possible, experts recommend following a specific order when securing funds for college. This “borrowing order” prioritizes free money and lower-cost federal debt before turning to private options.
- Grants and scholarships: Utilize free money first (no repayment required).
- Federal Work-Study: Earn money through part-time work if offered.
- Direct Subsidized Loans: Best loan option; need-based with no in-school interest.
- Direct Unsubsidized Loans: Available regardless of need; interest accrues immediately.
- Parent PLUS or private loans: Use these to fill any remaining funding gaps.
According to Betsy Mayotte, student loan expert, “In general, federal loans should be your first stop, but private loans can be appropriate when you’ve maxed out your federal eligibility.” Following this hierarchy ensures you exhaust the most consumer-friendly options before taking on private debt.
For a deeper dive into these trade-offs, read our Federal vs. Private Student Loans comparison guide. Let’s look more closely at the main federal loan types and how each one works differently.
Types of federal student loans
The U.S. Department of Education offers a few distinct loan programs under the William D. Ford Federal Direct Loan Program. Knowing the eligibility requirements and features of each will help you understand which loans you might be offered in your financial aid package.
Direct Subsidized Loans are available to undergraduate students with demonstrated financial need. The defining feature of these loans is that the U.S. Department of Education pays the interest while you are in school at least half-time, for the first six months after you leave school (your grace period), and during a period of deferment. This subsidy makes them the most affordable loan option available.
Direct Unsubsidized Loans are available to both undergraduate and graduate students and do not require a demonstration of financial need. Unlike subsidized loans, you are responsible for paying the interest on these loans during all periods. If you choose not to pay the interest while you are in school, it will accumulate and be added to your principal balance.
Direct PLUS Loans are available to two specific groups: parents of dependent undergraduate students (Parent PLUS) and graduate or professional students (Grad PLUS). Unlike the subsidized and unsubsidized options, PLUS loans require a credit check. If a borrower has an adverse credit history, they may still qualify by obtaining an endorser or documenting extenuating circumstances.
Direct Consolidation Loans allow you to combine all your eligible federal student loans into a single loan with a single loan servicer. This is typically done after graduation to simplify repayment (learn more in our guide to consolidation).
| Loan Type | Who Can Borrow | Need-Based? | Credit Check? | Interest While in School |
|---|---|---|---|---|
| Direct Subsidized | Undergraduates | Yes | No | Government pays |
| Direct Unsubsidized | Undergrads & Grads | No | No | Borrower responsible |
| Parent PLUS | Parents of undergrads | No | Yes | Borrower responsible |
| Grad PLUS | Graduate students | No | Yes | Borrower responsible |
Source: StudentAid.gov
Now that you know the federal loan types, let’s cover how much you can actually borrow through each program.
How much can you borrow? Federal loan limits
Federal student loans have strict limits on how much you can borrow each academic year (annual limits) and over your total education (aggregate limits). These caps protect students from taking on unmanageable debt, but they also mean federal loans may not cover the entire cost of attendance at expensive institutions.
Your borrowing limit depends on your year in school and your dependency status. Independent students (and dependent students whose parents are ineligible for PLUS loans) generally have higher borrowing limits than dependent students. Importantly, the amount of subsidized loans you can receive is capped within the total limit.
For Direct PLUS Loans, the limit is different. Parents and graduate students can borrow up to the full cost of attendance (determined by the school) minus any other financial aid received. This makes PLUS loans a powerful tool for covering remaining balances, though they come with higher interest rates and fees.
Ultimately, your school determines your specific loan offer based on these limits and your financial need. You cannot borrow more than your school’s official cost of attendance.
| Year in School | Dependent Student | Independent Student |
|---|---|---|
| First Year | $5,500 ($3,500 subsidized max) | $9,500 ($3,500 subsidized max) |
| Second Year | $6,500 ($4,500 subsidized max) | $10,500 ($4,500 subsidized max) |
| Third Year+ | $7,500 ($5,500 subsidized max) | $12,500 ($5,500 subsidized max) |
| Aggregate Limit | $31,000 ($23,000 subsidized max) | $57,500 ($23,000 subsidized max) |
Source: StudentAid.gov (limits effective for the 2025–2026 academic year)
If federal loans don’t cover your full cost of attendance, private loans can fill the gap. Here’s how private loans work differently.
Private student loans: Filling the gap
When federal aid and savings aren’t enough to cover college costs, private student loans can serve as a bridge to fill the remaining gap. These loans are issued by private financial institutions and operate differently than federal programs.
Private lenders determine your loan amount based on the school’s cost of attendance minus other aid, similar to PLUS loans. However, approval and interest rates are heavily dependent on your credit profile. Because most college students have limited credit history and income, they often cannot qualify for a private loan on their own.
This is where a cosigner comes in. A cosigner is usually a parent, guardian, or other creditworthy adult who agrees to take equal responsibility for the loan. The lender uses the cosigner’s credit score and income to determine approval and set the interest rate. If the student misses payments, the cosigner is legally obligated to pay, and the late payments will damage both parties’ credit scores.
Some private lenders offer a “cosigner release” feature. This allows the primary borrower to apply to remove the cosigner from the loan after making a set number of on-time payments (typically 12 to 48 months) and meeting specific credit and income requirements.
- Does the potential cosigner have stable income?
- Do they have strong credit (typically 670+)?
- Are they willing to assume responsibility if you can’t pay?
- Have you discussed a repayment plan together?
Private loans also offer a choice between fixed interest rates (which stay the same) and variable rates (which can fluctuate with market conditions). While variable rates might start lower, they carry the risk of increasing over time.
Whether you’re applying for federal or private loans, understanding the application process is your next step.
How to apply for student loans
Securing student loans involves specific steps that vary depending on whether you are seeking federal or private funding. Navigating these processes correctly ensures you get access to the funds you need on time.
- Complete the FAFSA: Visit StudentAid.gov to complete the Free Application for Federal Student Aid. This is the single application for all federal loans, grants, and work-study. According to StudentAid.gov, for the 2025–2026 academic year, the FAFSA opens on October 1, 2024.
- Review Your SAR: After submitting, you will receive a FAFSA Submission Summary (formerly the Student Aid Report or SAR), which includes your Student Aid Index (SAI). This number helps schools calculate your financial need.
- Receive Award Letters: The schools you listed on your FAFSA will send you financial aid award letters detailing the loans and other aid you are eligible for.
- Accept Your Loans: You must formally accept the loans you want to use. Remember, you do not have to accept the full amount offered—borrow only what you need.
- Complete Requirements: First-time borrowers must complete entrance counseling and sign a Master Promissory Note (MPN), a legal document in which you promise to repay your loan.
- Research and Compare: Look at multiple lenders to find the best rates and terms.
- Get Prequalified: Many lenders allow you to check potential rates with a soft credit inquiry, which does not affect your credit score.
- Submit Application: Once you choose a lender, you (and your cosigner) will complete a full application, which triggers a hard credit check.
- Provide Documentation: You may need to submit proof of income, tax returns, and enrollment verification from your school.
- Accept Terms: Review the final disclosures and sign the loan agreement.
Once your loans are approved, the next question is: how and when do you actually receive the money?
How loan disbursement works
Loan disbursement is the process of paying out the loan funds. For student loans, the money rarely comes directly to you first; instead, the lender sends the funds to your college or university.
Disbursement typically happens at the start of each academic term (semester, trimester, or quarter). The school applies the funds directly to your student account to pay for tuition, mandatory fees, and room and board if you live on campus. This ensures that your primary educational costs are covered before any money is released for other uses.
If your loan amount exceeds the direct charges on your student bill—for example, if you borrowed extra to cover off-campus housing, books, or transportation—the school will issue the remaining amount to you. This is called a credit balance refund. According to StudentAid.gov, schools are generally required to pay this refund to you within 14 days after the credit balance occurs.
Most loans are disbursed in at least two installments during the academic year; you generally won’t receive the entire year’s loan amount at once. Additionally, if you are a first-time borrower in the first year of an undergraduate program, federal regulations may require your school to wait 30 days after the first day of the payment period before disbursing your loan funds.
After disbursement, your loans enter “in-school status”—but interest may already be accumulating. Let’s look at what happens during school and the grace period.
In-school status and grace periods: When repayment begins
One of the major benefits of student loans is that you generally aren’t required to make full payments while you are focusing on your education. Understanding your loan status helps you avoid surprise bills and plan your post-graduation budget.
In-School Status: As long as you are enrolled at least half-time (typically 6 credit hours or more for undergraduates), your federal loans are placed in “in-school status.” During this time, no payments are required. However, it is important to remember that for unsubsidized and private loans, interest is likely still growing in the background.
Grace Period: After you graduate, leave school, or drop below half-time enrollment, federal loans enter a “grace period.” This is a six-month window designed to give you time to find employment and get your finances in order before regular payments begin. You do not have to make payments during the grace period, though you can if you choose to.
Exceptions:
- PLUS Loans: Parent PLUS loans technically enter repayment as soon as they are fully disbursed. However, parents can request a deferment to delay payments while the student is in school and for six months afterward.
- Private Loans: Grace periods for private loans vary by lender. While many offer a six-month grace period similar to federal loans, some may require small “interest-only” or flat-fee payments while you are in school. Always check your specific loan agreement.
While you’re not making payments during school, interest is often accumulating on your loans. Understanding how interest works is crucial to managing your total loan cost.
How interest works on student loans
Interest is the cost of borrowing money, calculated as a percentage of your unpaid principal balance (the amount you borrowed). On student loans, interest typically accrues daily. Understanding how this works is vital because it determines the total amount you will eventually repay.
The mechanics depend on your loan type. For Direct Subsidized Loans, the federal government pays the interest while you are in school and during your grace period. This means your balance stays the same until repayment officially starts. For Direct Unsubsidized Loans and most private loans, interest begins accruing the moment the funds are disbursed. If you don’t pay this interest as it accumulates, your loan balance grows even before you graduate.
A critical concept to understand is capitalization. This happens when unpaid interest is added to your principal balance. For example, if you graduate with $20,000 in loans and $2,000 in unpaid interest, capitalization turns your new principal balance into $22,000. Future interest is then charged on this higher amount—essentially, you start paying interest on your interest.
According to StudentAid.gov, for loans disbursed between July 1, 2024, and June 30, 2025, the fixed interest rate for undergraduate Direct Subsidized and Unsubsidized Loans is 6.53%. For Direct PLUS Loans (parents and grad students), the rate is 9.08%. Private loan rates vary widely based on creditworthiness and market conditions.
Now that you understand how interest accumulates, let’s look at what happens when you enter repayment and the options available for managing your monthly payments.
Introduction to repayment: What happens after graduation
Once your grace period ends—typically six months after you leave school—your loans officially enter repayment. At this point, you will begin making monthly payments that cover both the accruing interest and a portion of the principal balance.
For federal loans, you are automatically placed on the Standard Repayment Plan, which sets a fixed monthly payment amount designed to pay off your loans in 10 years. This plan results in the least amount of interest paid over time but often has the highest monthly payments. However, federal loans offer significant flexibility if the standard payment is too high.
Income-Driven Repayment (IDR) plans calculate your monthly payment based on your income and family size, rather than your total debt. Under plans like the SAVE Plan or IBR, payments can be as low as $0 per month for low-income borrowers. Additionally, if you make payments on an IDR plan for 20 or 25 years (depending on the plan), any remaining balance may be forgiven.
Private student loans work differently. Your repayment terms are set by the contract you signed with the lender. Terms typically range from 5 to 20 years. Private lenders generally do not offer income-driven repayment plans or forgiveness, making them less flexible if your income drops.
| Plan Type | Payment Structure | Term Length |
|---|---|---|
| Standard | Fixed monthly | 10 years |
| Graduated | Starts low, increases | 10 years |
| Extended | Lower fixed or graduated | Up to 25 years |
| Income-Driven | Based on income | 20-25 years |
Source: StudentAid.gov
Your loan servicer plays a key role in managing your loans throughout repayment. Let’s look at what servicers do and how to work with them.
The role of loan servicers
You generally do not repay the Department of Education directly. Instead, your loan is assigned to a loan servicer—a private company that handles the billing and other administrative tasks for your federal student loans. They are your primary point of contact for everything related to your debt.
Servicers are responsible for sending your billing statements, processing your payments, and helping you manage your account. If you need to switch repayment plans, apply for deferment or forbearance, or certify your income for an IDR plan, you will work through your servicer. For federal loans, the government assigns your servicer; you cannot choose them yourself.
To find out who services your federal loans, you can log in to your dashboard at StudentAid.gov. For private loans, your servicer is typically the lender you borrowed from, or a third-party company they have hired. It is crucial to keep your contact information updated with your servicer so you never miss important correspondence.
Understanding what can happen if you don’t repay your loans helps reinforce why staying in contact with your servicer matters.
What happens if you don’t repay: Understanding default
Failing to repay student loans can have serious, long-term financial consequences. It is important to distinguish between delinquency and default. You become delinquent the first day after you miss a payment. If delinquency continues, your loan eventually goes into default.
According to StudentAid.gov, for most federal loans, default occurs after 270 days (about 9 months) of non-payment. The consequences are severe: the entire unpaid balance becomes due immediately (acceleration), your credit score will drop significantly, the government can garnish your wages, and your tax refunds may be seized. You also lose eligibility for additional federal student aid and repayment flexibility.
Private loans can go into default much faster—sometimes after just three missed payments—and lenders can take you to court to collect the debt.
To wrap up, let’s review the key terms every borrower should know.
Key student loan terms every borrower should know
Student loans come with their own vocabulary. Keeping these terms straight will help you navigate your promissory notes and repayment options with confidence.
- Principal: The original amount of money you borrow before interest is added.
- Interest Rate: The percentage of the principal charged by the lender for the privilege of borrowing money.
- Capitalization: The process where unpaid interest is added to your principal balance, increasing the total amount you owe.
- Loan Term: The set period of time you have to repay the loan (e.g., 10 years, 20 years).
- Disbursement: The payment of loan funds by the lender to the school.
- Grace Period: The set time after leaving school before you must begin making principal and interest payments.
- Loan Servicer: The company that collects payments, responds to customer service inquiries, and performs other administrative tasks.
- Deferment: A temporary postponement of payment on a loan that is allowed under certain conditions; interest generally does not accrue on subsidized loans.
- Forbearance: A period during which your monthly loan payments are temporarily suspended or reduced; interest continues to accrue on all loan types.
- Default: Failure to repay a loan according to the terms agreed to in the promissory note.
With these fundamentals in mind, you’re ready to make informed decisions about financing your education.
Student loans are a powerful tool for accessing education, but they require careful management from application through repayment. By understanding the lifecycle of a loan—from the initial FAFSA application and disbursement to the grace period and eventual repayment—you can borrow responsibly and avoid unnecessary costs.
Key Takeaways:
- Start with federal loans by completing the FAFSA before considering private options.
- Understand the difference between subsidized loans (where the government pays interest) and unsubsidized loans.
- Loan funds are sent directly to your school first; any excess is refunded to you for living expenses.
- Repayment typically begins six months after you leave school, but interest may accrue while you study.
- Stay in contact with your loan servicer—they are your partner in managing repayment and avoiding default.
Remember, borrowing for college is an investment in your future. Armed with the right information, you can navigate the process with confidence and keep your financial goals on track.
Many or all of the products presented on this page are from sponsors or partners who pay us. This compensation may influence which products we include, as well as how, where, and in what order a product appears on the page.
Frequently asked questions about student loans
For federal loans, FAFSA processing typically takes 3-5 days, but funds are disbursed by your school at the start of each term. Private loan applications can be approved in as little as a few minutes to a few weeks, with disbursement coordinated directly with your school’s financial aid office.
Yes, federal student loans do not require a cosigner or a credit check (except for PLUS loans). However, most undergraduate students will need a creditworthy cosigner to qualify for private student loans due to limited credit history and income.
The main difference is who pays the interest. For Direct Subsidized Loans, the government pays the interest while you are in school and during grace periods. For Direct Unsubsidized Loans, interest begins accruing as soon as the loan is disbursed, and you are responsible for paying it.
For most federal loans, repayment begins after a six-month grace period that starts when you graduate, leave school, or drop below half-time enrollment. Private loan terms vary; some may require small payments while you are in school, while others offer a similar grace period.
According to StudentAid.gov, federal loan limits depend on your year in school and dependency status, ranging from $5,500 to $12,500 annually for undergraduates. Private lenders typically allow you to borrow up to your school’s total cost of attendance minus any other financial aid you receive.
- StudentAid.gov – The official source for information on federal student aid, loan types, and repayment plans.
- FAFSA.gov – The official portal to complete the Free Application for Federal Student Aid.
- Consumer Financial Protection Bureau (CFPB) – Provides guides and tools for understanding student loans and submitting complaints.
- Federal Student Aid Information Center – For questions about federal loans, call 1-800-4-FED-AID.
- Federal vs Private Student Loans: Complete Guide
- Understanding FAFSA: Step-by-Step Guide
- Student Loan Repayment Plans Explained
- Private Student Loan Guide
