Student Loans: What They Are and How Do They Work?

Affording higher education has become increasingly difficult for students and families. As of 2024, college students pay an average of $108,584 for four years of in-state tuition.

Because most people don’t have that kind of cash on hand, it’s no wonder nearly 60% of undergraduate students take out federal or private loans. Aside from home mortgages, federal student loans are America’s most common type of consumer debt, amounting to $1.617 trillion in 2024. However, it pays off for many in the long run. Those with a bachelor’s degree typically earn 75% more than workers with only a high school diploma.

But how do student loans work, exactly? And which type of student loan is right for you? Our comprehensive guide tells you everything you need to know about applying for and repaying student loans in 2024. 

What Are Student Loans?

A student loan is a lump sum of money borrowed from the government or a private organization to pay college tuition and other expenses. Like any type of loan, you must repay it in full over time, plus interest. However, student loan repayments are typically delayed until the student finishes college. 

You can use student loans to pay for undergraduate or graduate education. In fact, 65% of all federal student debt comes from students in graduate programs. 

Student loans differ from grants and scholarships in several ways. Most importantly, student loans must be repaid, while grants and scholarships are considered gifts you don’t have to pay back. Grants are based on financial need, while scholarships are considered achievement awards based on academics, athletics or other areas.

Grants and scholarships are often highly competitive and difficult to obtain, reserved for only the most in-need students. Loans are a much more common type of funding, with fewer requirements and greater accessibility to students.

How Do Student Loans Work?

Student loans fund all types of post-secondary education and the expenses associated with college, such as books, living costs and tuition. Here’s a look at how it works:

Funding

To secure student loan funding, students must complete an application process in which they share financial information, personal information and details about the schools they hope to attend. Some private lenders require proof of enrollment before approving a loan.

Most loans have borrowing limits that depend on the year in school or the level of financial need. Private loans may have higher limits, but those funds come with higher interest rates.

Once the lender approves the loan, it sends funds to the school to cover tuition, fees and more. Leftover funds go to the student to pay for other school-related expenses.

Interest

Interest rates and terms differ depending on the type of student loan. For example, federal loans usually come with fixed interest rates set by the government. With Direct Subsidized Loans, the government pays interest until a student graduates. For Direct Unsubsidized Loans, interest accrues immediately, even while the student is in school.

Private student loans can come with fixed or variable interest rates. In either case, interest rates tend to be higher than federal loans, and interest starts accruing right away.

Repayment

Federal student loans usually don’t require students to start paying back the loan until six months after graduation. The terms of private loans vary, with many requiring payment while students are still in school. Students can typically choose a repayment plan that works for them, either paying a set amount each month or paying variable amounts based on income.

Types of Student Loans

Federal student loans make up nearly 93% of all student loan debt, while private loan borrowers make up just 7%. There’s a reason for the stark imbalance. Federal student loans offer more favorable benefits and protections to borrowers. Here’s what you should know about each option.

Federal Student Loans

As the name suggests, federal loans are issued by the federal government: the U.S. Department of Education, to be exact. These loans typically come with better rates and more flexible repayment options than private student loans.

The four most common types of federal student loans are: Direct Subsidized Loans, Direct Unsubsidized Loans, Direct PLUS Loans and Direct Consolidation Loans.

Private Student Loans

With all the benefits offered by federal student loans, private student loans are often seen as a last resort. Most students only consider them if their education costs exceed the federal loan maximums or if they are international students who aren’t eligible for federal loans.

Financial institutions like banks and credit unions issue private loans. Unlike federal loans, they do require a credit check. Terms, interest rates and limits all vary depending on the lender and the borrower’s credit history. 

Applying for Student Loans

It’s a good idea to apply for grants and scholarships before applying for student loans. Remember, grants and scholarships don’t have to be paid back, while student loans do. After exploring those options, it’s best to start with federal student loan applications, because federal loans offer more flexible, favorable terms and repayment plans. Consider private loans once all other options are off the table.

Here’s how to apply for student loans:

1. Check Eligibility

Most college students qualify for federal or private student loans, but it’s important to make sure before moving forward with the process. Here are the basic requirements:

• U.S. citizenship
• Valid social security number
• High school diploma or GED certificate
• Maintain baseline academic requirements

2. Complete the FAFSA Form

After confirming eligibility, students must complete the FAFSA form by the specific state deadline. This form is required for all federal and state financial aid programs, including grants and scholarships. To complete the form, students will need to provide the following:

• Parent information
• Date of birth
• Social security number
• Email address
• Income information

3. Review Student Aid Report

Once the FAFSA is completed and reviewed, students receive a Student Aid Report detailing all offers for financial aid. Students can accept or decline offers based on college costs.

Managing Student Loan Debt

It’s never too early to think about managing your student loan debt. In fact, the sooner you consider your repayment plan, the better.

Federal loans come with several repayment options, either based on your income or based on a fixed rate over time. Be sure to compare repayment plans using a loan simulator, which estimates monthly payments and time frames for repayment.

Here are some other tips for managing student loan debt:

• If possible, pay more than what’s due every month (make sure you’re exempt from early payment fees)
• Sign up for autopay
• Consider paying twice a month (with every paycheck)
• Refinance or consolidate loans to save money over time
• Seek out employers that offer loan repayment assistance

Student Debt Forgiveness Programs

Students with federal loans sometimes qualify for loan forgiveness programs. In this scenario, loans are forgiven, canceled or reduced by working in public service or at a qualifying nonprofit organization.

You may qualify for loan forgiveness if you:

• Teach in a low-income school
• Are a government employee
• Work at a nonprofit 
• Work as a nurse, doctor, or medical professional at a qualifying not-for-profit organization
• Have a disability
• Repay loans under an income-driven repayment plan

Public Service Loan Forgiveness (PSLF) is the most common loan forgiveness program. Visit the PSLF website to learn more about the application process.

Pros and Cons of Student Loans

Federal student loans are generally seen as more desirable than private student loans. Let’s take a look at some of the benefits:

• No credit check required: Most federal loans don’t require a personal credit check. Students won’t be denied based on a low credit score or lack of credit history.
• Lower, fixed interest rates: Interest rates are typically lower than private loan rates. They also stay at the same rate for a full year, and rates are the same for all borrowers, no matter their credit score or borrowing amount.
• Subsidized loans: Low-income students may be eligible for subsidized loans, in which the government pays interest while students are in school.
• No prepayment penalties: Unlike many private loans, students won’t be charged a fee if they decide to pay off loans ahead of schedule.
• Flexible repayment plans: Students can choose from a variety of repayment plans, including income-based repayment that’s determined by earnings.
• Loan forgiveness: Students working in public service or low-income areas may qualify for loan forgiveness or cancellation.
• Deferment options: Federal loans usually have more generous deferment options than private loans, allowing students to take time off school without worrying about loan repayment.
• Loan consolidation: Students may choose to consolidate their federal student loans to lower monthly payments or get other benefits.

The main downside of federal student loans is that they come with more strict borrowing limits. If the maximum borrowing limit is lower than what a student needs to pay for school, private loans may be necessary to make up the difference. Another drawback is only American students can apply for federal student loans — international students don’t qualify.

Now let’s review the pros and cons of private loans:

• Higher interest rates: Private loan interest rates are usually higher than federal rates. They may also be variable, meaning monthly payments could increase when rates peak.
• Less flexible terms: Most private lenders don’t offer income-driven repayment plans.
• No loan forgiveness: Loan forgiveness isn’t an option with private student loans.
• No subsidies: Interest starts accruing as soon as the loan is disbursed, no matter the student’s income level.
• Requires a credit check: Private loans require a credit check, and a poor credit score or limited history could result in less favorable terms.
• Potential deferment options: Some private lenders offer loan deferment, but terms are usually less favorable than federal loans.
• More generous limits: Private loans are usually more flexible with borrowing limits, although they come at a higher cost.
• International students may qualify: Unlike federal loans, some private student loans are available to international students.

Alternative to Student Loans

Student loans aren’t the only way to pay for higher education. Grants and scholarships are an even better choice because they don’t have to be repaid. Just keep in mind these options typically are based on financial need or achievement, and they can often be highly competitive and difficult to obtain. Loans are a much more common type of funding, with fewer requirements and greater accessibility to all students.

If you aren’t able to secure enough grants and scholarships to cover the cost of your education, consider exploring these alternatives:

• Savings/529 Plans
• Working during school
• Income share agreements
• Employer-paid tuition programs
• Work-study programs
• Stipends
• Tuition waivers

The cost of college can certainly feel overwhelming. Thankfully, student loans help bridge the gap and make higher education more accessible for all income levels. If you’re applying for college, be sure to explore all financial aid options to help support your financial needs. After grants and scholarships, federal student loans are most ideal — but private loans also have their place if federal loans fall short.