understanding student loans

Student Loan Basics

Michael Lux Basics, Blog, Student Loans 0 Comments

Student loans are often the subject of confusion.  To some, they are all pretty much the same.  To others, student loans are incredibly complicated and difficult to understand.

Before jumping into repayment strategy and digging into tips and tricks for eliminating the debt, it is critical that a borrower understand the basics of student debt.  Armed with a basic understanding of how student loans work, borrowers are much better equipped to understand ad evaluate different options.

What is a Student Loan?

A student loan is nothing more than a contract between a lender and a borrower.  The lender provides money to pay for school and other related costs and the borrower agrees to repay the loan per the terms of the contract.

In a student loan agreement, the lender is exchanging money in the present so that it can collect a greater sum of money in the future.  Borrowers agree to these terms because they are betting that an education will enable them to afford to pay of the loan with interest per the terms of the agreement.

The most common student loan agreement is the Master Promissory Note (MPN).  The MPN is the agreement between the federal government and student loan borrowers.  Each student has to complete the MPN in order to receive federal student loans.

Many consumers agree to contracts all the time without reading the actual terms and conditions.  The MPN and other student loan agreements should be an exception.  Though it is certainly a boring read, the language matters.

Student loan contracts from private lenders can vary greatly from one lender to the next.  Not only do the interest rates vary greatly, but some lenders try to sneak in terms that are unfair to consumers.  When such terms are in the agreement, it is often best to reach out to other lenders to find a more fair deal.

Common Student Loan Terms to Understand

Even though all student loan contracts are different, many have similar terms and provisions that all borrowers should find and understand.

Repayment Length – The repayment length is the amount of time that a borrower has to repay the loan.  Some contracts offer multiple repayment plans to provide borrowers multiple options.  Repayment plans can be as short as five years, while some give borrowers up to 20 years.  The shorter repayment length will generally mean higher monthly payments, but it often comes with a lower interest rate.  Longer repayment length can mean lower minimum payments, but more interest will be paid over the life of the loan.

Interest Rate – Interest is the profit that a lender makes off of the loan.  Typically, the loan generates interest on a daily basis and the interest is added to the balance of the loan each month.  With the exception of federal subsidized loans, interest accrues while a student is in school, even if they are not responsible for making any payments.  This means that loans borrowed early in school can grow significantly before the borrower actually begins repayment.

Fixed vs Variable Rate – The two types of interest rates on loans are fixed and variable rate loans.  A fixed rate means that the interest rate in the original agreement remains the same for the life of the loan.  A variable rate means the interest rate can go up or down along with market fluctuations.  Variable rates usually start lower than fixed rates, but the danger is that interest rates will rise making the long more expensive in the long run.

Origination Fees – Borrowers will typically want to avoid loans with origination fees, unless they are federal loans.  Origination fees are an expense that is added to the balance of the loan from the beginning.  Often the origination fees is listed as a percent.  For example, if a borrower gets a $10,000 student loan with a 3% origination fee, the balance they agree to repay from day one would be $10,300.  The origination fee makes the balance larger from the beginning and causes the loan to generate more interest over the life of the loan.

Co-Signers – Many borrowers use co-signers to help qualify for the loan.  Having a co-signer can also help a borrower secure a lower interest rate.  The risk with having a co-signer is that the co-signer shares the responsibility to pay back the loan in the event the borrower fails to repay.  Co-signers accept a great deal of risk with no reward for doing so, as a result co-signers are usually parents or guardians of children heading to school.

Default – Most loans will include a default provision where the entire balance of the loan becomes due in full.  A common version of this clause would be in the event a borrower fails to make any payments on the loan for an extended period of time.  However, there are some default clauses that borrowers should avoid.  Some lender contracts call for a default in the event a borrower or co-signer dies or declares bankruptcy.  This can cause an extreme hardship for the individual stuck with the bill and these terms should not be agreed upon.

How Do I Get a Student Loan?

Federal loans are the preferred loans for nearly all students and they are the easiest to acquire.  Students need to complete their school’s financial aid paperwork and fill out the FAFSA.  Even though the FAFSA does provide some need based aid, it also provides student loans to borrowers from all backgrounds.  If the children of Bill Gates needed student loans, they could fill out the FAFSA and qualify for federal loans.

Private loans can be acquired by applying directly with the individual lenders.  In order to secure approval, borrowers and their co-signers will have to pass a credit check.  We suggest shopping around in order to find the lender offering the lowest rates and the best terms.  All lenders have different formulas for evaluating applicants, so the interest rates offered can vary greatly.  Once the loan agreement has been signed, the lender typically sends the money to the school’s financial aid office.  Funds needed for living expenses are issued to the student from the school once tuition and fees have been paid in full.  The financial aid office at any school can share specific details on their procedure.

There are also limitations on total borrowing that borrowers should understand.  These limits can be found here.

What Can I Use Student Loans For?

Student Loans are able to be used for far more than just tuition.

Borrowers are allowed to borrow student loans for the following:

  • Room and Board
  • Institutional fees
  • Books
  • Supplies
  • Equipment
  • Dependent care expenses
  • Transportation
  • Commuting expenses
  • Rental or purchase of a personal computer
  • Loan fees
  • Other documented, authorized costs

Borrowers with specific questions about whether or not an expense can be covered by student loans should consult their schools financial aid office.

A Warning to Borrowers

Despite involvement from the government, schools, and various lenders, the only person responsible for evaluating whether or not a loan is a good idea is the borrower.

The government’s goal is to make funds available so that students can afford school.  Financial aid offices want to make sure students pay their tuition each semester.  Lenders don’t care whether or not the school is a good investment, because they know borrowers have no choice but to repay the debt due to limited consumer protections.

The duty of any smart borrower is to carefully evaluate how much they are borrowing and whether or not they will be able to comfortably pay back the debt after graduation.  During school student loan money feels almost like monopoly money… easy to acquire and seemingly limitless.  After school has ended, the debt becomes very real and very painful.

The only person who can avoid living a student loan nightmare is the borrower, and that requires smart and careful decisions during school.