How Federal Student Loans Work

The federal student loan system in the United States is designed to help students finance their college education, making it more affordable. But even with the opportunities student loans provide, few of us understand how they really work. Note: the information in this post is accurate as of late February, 2025. Changes may occur afterwards.

The Why of Student Loans

A college education has often been a financial strain for families. And while some would argue that the current price tag far outstripped the ability families to pay, the federal government has provided loans since the 1950s, through the National Defense Education Act.

Types of Federal Student Loans

The US Department of Education offers several types of federal student loans. Each is explained below.

1. Direct Subsidized Loans: These loans are available to undergraduate students with demonstrated financial need. The government pays the interest on these loans while the student is in school, and during the six-month grace period after graduation. The government may also pay the interest during deferment periods.
2. Direct Unsubsidized Loans: These are available to both undergraduate and graduate students, regardless of financial need. Interest accrues on these loans from the time they are disbursed.
3. Direct PLUS Loans: These are available to graduate students and parents of dependent undergraduate students. They cover up to the full cost of attendance minus any other financial aid received.
4. Direct Consolidation Loans: People taking these out are combining multiple federal student loans into a single loan with a single loan servicer.

Federal Student Loans vs Private Loans

Federal student loans offer several advantages over private loans. For one thing, unlike many private loans, federal loans have fixed interest rates that don’t change over the life of the loan.

In addition, many don’t require a credit check or cosigner, making them more accessible to students. An additional feature is income-driven repayment plans, which adjust the monthly payment based on income and family size.

Loan forgiveness is an option too. For people entering certain professions, such as teaching or public service, may qualify for loan forgiveness after a specified period of time. Finally, federal student loans also offer deferment and forbearance options: These allow borrowers to temporarily pause or reduce payments when they’re experiencing financial hardship.

Applying for Federal Student Loans

The first step in applying for federal student loans is to complete the Free Application for Federal Student Aid (FAFSA). I’ve said many times that people should always complete and submit the FAFSA, even if they don’t believe they will be eligible for financial aid of any kind. This is because many universities require students applying for any form of financial assistance to complete the FAFSA first, even for loans that are not need-based. The FAFSA collects information about the student’s and parents’ income, assets, and other relevant factors to determine eligibility for federal aid.

And yes, it is rather challenging to complete. Look for sources of help in your community, such as presentations on the FAFSA at the local library or other locations. Help is available if you look for it.

Next Steps

Once you have completed the FAFSA, you’ll receive a summary. This lists the student’s potential eligibility for federal loans and their Student Aid Index (SAI).

Another important task is to determine the amount you want to borrow. Students should carefully consider this, taking into account their expected future income and ability to repay. In other words, a future teacher might consider borrowing less than a future engineer.

Student Loan Terms and Conditions

Federal student loans come with several specific terms and conditions. Interest rates on student loans are set annually by Congress. For the 2024-2025 academic year, undergraduate Direct Subsidized and Unsubsidized Loans have an interest rate of 6.53%, while Graduate Unsubsidized Loans are at 8.08%.

Beyond interest rates, there are also annual and lifetime maximum amounts that can be borrowed. This may impact the range of universities your student can afford to attend. For example, dependent undergraduates can borrow up to $31,000 in total, with no more than $23,000 in subsidized loans.

Repaying your federal student loan is relatively straightforward. The standard repayment term  is ten years with fixed payments, but there are various repayment plans available, including options that are income-driven repayment. Keep in mind though, that payment amounts may be substantial depending on how much your student borrowed.

Repayment begins after the standard six-month grace period following graduation. This gives new graduates time to get a job before their repayment begins.

There are several repayment plans available, including:

1. Standard Repayment Plan
2. Graduated Repayment Plan
3. Extended Repayment Plan
4. Income-Based Repayment (IBR)
5. Pay As You Earn (PAYE)
6. Revised Pay As You Earn (REPAYE)
7. Income-Contingent Repayment (ICR)

You can find information on all of these options at studentaid.gov.

Conclusion

The US federal student loan system provides a crucial financial resource for millions of students pursuing higher education. These loan options, combined with college savings, merit awards and payment plans, help to make to make college more accessible and affordable. However, students should carefully consider their borrowing needs and future ability to repay before taking on any loans.