What Are Student Loans and How Do They Work?

on April 13, 2016

College is expensive. After you’ve used your savings, income and free money like scholarships and grants, you may still need more money to pay the college bills. That’s where student loans come in.

Student loans are borrowed money. They have to be repaid, usually with interest.

This introduction gives a basic overview of student loans for people who are new to borrowing money to pay for college.

Need help understanding some of these student loan terms? Our student loan glossary can help.

Types of Loans


There are two main types of student loans: federal and non-federal. Non-federal loans include state loans, institutional loans and loans from private lenders. More than 90 percent of new education loans each year are federal.

Federal student loans include the Federal Stafford Loan, Federal Perkins Loan and Federal PLUS Loan. The Federal Stafford Loan has two versions, subsidized and unsubsidized. The Federal PLUS Loan is available to graduate students (Federal Grad PLUS Loan) and to parents of dependent undergraduate students (Federal Parent PLUS Loan).

In general, students should borrow federal first because federal student loans are cheaper, more available and have better repayment terms than private student loans.

How to Apply for a Student Loan


To apply for a federal student loan, the student must file the Free Application for Federal Student Aid (FAFSA) at www.fafsa.ed.gov after obtaining a FSA ID at www.fsaid.ed.gov. The FSA ID is used to sign the FAFSA electronically.

After receiving the financial aid award letter, the student will participate in loan counseling at https://studentloans.gov. Then, the student will sign the Master Promissory Note (MPN), using the FSA ID. A promissory note is a legal document in which the borrower agrees to repay the debt. A Master Promissory Note covers all loans made within a continuous period of enrollment of up to 10 years.

For private student loans, the borrower must apply directly with the lender. Most private student loans are credit underwritten, meaning that the lender will base the decision to lend and the interest rate and fees on the borrower’s credit scores. If the borrower does not have a good credit score, the lender will require a cosigner. A cosigner is a co-borrower, equally obligated to repay the debt. More than 90 percent of private student loans to undergraduate students require a cosigner.

When Do You Get Your Student Loan Money? 


The loan proceeds are sent from the lender to the college. The college will apply the loan money first to institutional charges for tuition and fees. If the student is living on campus in college housing, the money is also applied to charges for room and board. Any remaining credit balance will be refunded to the student within 14 days. This money can be used to pay for textbooks, supplies, equipment, transportation to/from school and other educational costs.

Some students will spend the student loan money on eating out, entertainment and gadgets. But, every dollar of student loan money will cost about two dollars by the time you repay the debt. So before you spend student loan money on anything, ask yourself if you’d still buy it at twice the price.

Loan Limits


A loan limit is the maximum amount you can borrow through the student loan program. Often a loan will have annual limits and cumulative limits. Annual limits may vary by year in school (e.g., freshman vs. sophomore vs. junior vs. senior), dependency status (e.g., dependent vs. independent) and degree level (e.g., undergraduate vs. graduate student).

This table shows the overall loan limits for undergraduate students the Federal Stafford Loan program, based on year in school and dependency status.


Year in School Federal Stafford Loan Dependent Student Loan Limits Federal Stafford Loan Independent Student Loan Limits




Sophomore $6,500 $10,500
Junior $7,500 $12,500
Senior $7,500 $12,500
Cumulative $31,000



The subsidized Federal Stafford Loan has lower loan limits that are the same for dependent and independent students. Eligibility for the subsidized Federal Stafford Loan is also based on financial need. Eligibility for the unsubsidized Federal Stafford Loan is equal to the overall limits minus the amount of any subsidized Federal Stafford Loans.


Year in School Subsidized Federal Stafford Loan Limits
Freshman $3,500
Sophomore $4,500
Junior $5,500
Senior $5,500
Cumulative $23,000


Don’t borrow to the limit, however, just because you can. If you borrow too much, you’ll pay for it later. Live like a student while you’re in school, so you don’t have to live like a student after you graduate. If you borrow too much, it can be like having a small mortgage without owning a home. For most college graduates, student loan debt is the difference between owning a luxury vehicle and a used car.

Sometimes students who reach the Federal Stafford Loan limits turn to the Federal PLUS Loan or private student loans. Needing to borrow from the Federal PLUS loan or private student loans, however, may be a sign of over-borrowing. Try to estimate how much debt you’ll have when you graduate and what the monthly payment will be on a 10-year repayment term.  

Your total student loan debt at graduation should be less than your expected annual starting salary. If total student loan debt is less than your annual income, you should be able to repay your student loans in ten years or less. If total student loan debt is greater than your annual income, you’ll struggle to make the loan payments and will need an alternate repayment plan, like extended repayment or income-driven repayment, to afford the monthly loan payments. These repayment plans reduce the monthly payment by stretching out the term of the loan. But, increasing the term of the loan increases the total interest paid over the life of the loan. It also means that you’ll still be repaying your own student loans when your children enroll in college.

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