How Do Student Loans Work?
March 19, 2025
Student loans are an important resource for students who are seeking financial support for college. But the process of securing a student loan can be complex.
Being as informed as possible before signing on the dotted line helps students make decisions that are best for them and their college journey.
In this post, we've rounded up some frequently asked questions about what student loans are and how they work — and provide some answers.
What is a Student Loan?
A student loan is a financial aid option that allows students to borrow money to pay for their college expenses. Loans can be used to pay for tuition, fees, housing, books and other educational costs.
Student loans are paid back with interest after the borrower has graduated.
How do Student Loans Work?
Not every student loan is created equal, but in general, they work like this:
- A student applies to borrow money from a lender to pay for college.
- Once approved, loans are disbursed to the borrower's school at the beginning of each semester.
- Loans are used to pay tuition and other fees, and the rest is transferred to the student, upon request, if a refund is available.
- The student must pay back the loan in accordance with the loan's repayment terms.
Different loans have different repayment terms and interest rates, but other than that, most loans follow a similar application and disbursement process.
What are Federal Student Loans?
Federal student loans are issued by the government. The benefit of federal student loans is that they typically have lower interest rates. Plus, these interest rates are fixed, so you don't have to worry about potentially having to pay more than you originally signed up for.
However, since the financial need is a consideration for federal student loans, some students may need additional funding from a private lender to cover all of their college costs.
Types of Federal Student Loans
There are two main types of federal student loans: Subsidized and Unsubsidized.
Subsidized student loans have most of their interest paid by the government. These loans are for students that demonstrate financial need. Subsidized loans do not begin to accrue interest until six months after graduation or until the student drops below half-time enrollment.
Unsubsidized student loans, on the other hand, require the borrowers to pay back the interest after disbursement. These loans do not require proof of financial need.
There are also federal loans for the parents of students and graduate students. These loans have higher interest and have an application process that is a bit more involved, but they are available for those who need them.
What are Private Student Loans?
Private student loans are from non-government lenders. They can come from banks and other financial institutions.
Private student loans differ from federal loans in that they are generally not based on financial need. Instead, lenders assess creditworthiness, considering factors such as your credit score, income, debt-to-income ratio and — if applicable — the strength of a cosigner.
While qualifying for a private loan can be easier since financial standing isn't a determining factor, this accessibility often comes at a price. Private loans typically carry higher interest rates, offer less flexible repayment terms, and lack the borrower protections available with federal loans (such as loan forgiveness, deferment or income-driven repayment plans). As a result, while these loans may seem convenient, they can be more costly and offer fewer safeguards over time.
What is FAFSA?
Any students who are interested in federal student loans must fill out the Free Application for Federal Student Aid (FAFSA) form annually.
This application is available online and used to determine how much financial support a student needs based on their family's estimated ability to contribute.
The William D. Ford Federal Direct Loan Program offers Direct Subsidized and Direct Unsubsidized Loans to most students who complete the FAFSA, even if they do not demonstrate significant financial need.
For dependent undergraduate students, the annual loan limits typically range from $5,500 to $7,500, depending on the student’s year in school.
Paying Back Student Loans
As mentioned, the repayment terms vary from loan to loan. But typically, students are required to start making payments within a set period after graduating.
When it comes to the length of repayment periods, federal loans must be paid back within 10 years, but private loans may vary.
For federal loans, there are several possible repayment plans. A few of the most common repayment plans include:
- Standard repayment plans: The loan is repaid in set monthly payments over the course of a determined repayment period.
- Graduated repayment plans: The loan is repaid in monthly payments that start out low and grow over time.
- Extended repayment plans: The loan can be repaid with either standard or graduated payments over the course of an extended time period (typically up to 25 years).
Be sure to check the repayment terms of your loan before you sign so that you can plan accordingly.
Understanding Interest on Student Loans: What You Need to Know
When it comes to financing your education, interest is one of the most critical factors to consider. It can significantly affect how much you'll ultimately repay — often more than the loan amount itself.
There are two primary types of interest to understand: simple and compounding. Knowing the difference can help you make informed decisions about borrowing and managing your loan effectively.
Simple Interest: A Straightforward Calculation
With simple interest, you only pay interest on the principal — the original amount you borrowed. This structure is straightforward and often more manageable over time.
Here's how it works:
If you borrow $100,000 with a 5% simple interest rate, your annual interest would be $5,000. Throughout the life of the loan, you continue to pay interest based solely on that original $100,000, not on any accrued interest.
Good news: Most federal student loans and many private student loans use simple interest. This structure tends to be more predictable and cost-effective, making it easier to plan for long-term repayment.
Compounding Interest: Interest on Interest
Compounding interest, however, can be a different story. With compounding interest, you pay interest not only on the principal but also on any interest that has already accrued. In other words, the interest itself begins to accumulate additional interest over time.
Let's look at a simplified example:
Imagine you borrow $100,000 with a 6% compounding interest rate. After the first year, you would owe $6,000 in interest. Instead of resetting each year, that amount gets added to your principal, meaning the following year's interest is calculated at $106,000.
The result? Your loan balance can grow faster than you expect, making it more expensive over time. This is why understanding the terms of your loan is crucial before signing on the dotted line.
Private student loans often use the simple interest previously described, but not always. Some lenders apply compounding interest, especially for specialized loans or those with longer repayment terms.
Student Loan Alternatives
Borrowing money to pay for college can be a significant, long-term undertaking. That's why many students seek alternative financial aid options that don't need to be paid back.
Here are a few student loan alternatives to consider.
Scholarships
Scholarships are a student loan alternative that students can earn in a variety of ways. Some popular types of scholarships include academic scholarships, sports scholarships and creative scholarships.
Scholarships come with guidelines that students must uphold. Typically, students must maintain a minimum GPA, enroll with a full-time schedule, and participate in a specific organization that they've committed to (such as an honors organization or a sports team).
As long as students uphold their end of the agreement, the money does not need to be repaid.
Grants
Grants are a type of financial aid that is typically need-based rather than performance-based. They can come from both federal and private institutions. Some grants are one-time stipends, whereas others are dispersed at the beginning of each semester or split in half over the course of the academic year.
Like scholarships, students who remain in good standing with the university and the institution that is dispersing the grant do not need to repay.
Work-Study
If you're looking for an alternative to traditional student loans, a work-study program could be a smart solution. These programs offer more than just financial support — they provide valuable work experience that can enhance your resume while helping cover educational costs.
In a work-study program, you'll likely take on a part-time campus job while enrolled in school. The wages you earn can be used to help pay for tuition, cover living expenses or support other educational needs. It's a practical way to ease your financial commitment without taking on additional debt.
Some work-study programs are federally funded and are only for students who demonstrate financial need. On the other hand, school-funded work-study programs often have less rigid requirements.
Looking for more information on funding college? Head over to Bucknell University's Financial Aid page to access additional resources.
