Interest is no fun unless you are earning it. When you have to pay for it, it can be a major hindrance. It’s even worse when you have capitalized interest that starts to compound. So how do you avoid that? Keep reading to learn more about how capitalized interest works and how borrowers can avoid it or pay it off on their student loans.

What is capitalized interest?

In simple terms, capitalized interest is when unpaid interest is added to the principal balance of your loan and then your lender charges your existing interest rate on the new, higher balance.

Essentially, your outstanding interest charges are added to your total loan balance—and interest is charged on the higher balance. Student loans are among the most common places to find a capitalized interest example.

Capitalized interest student loan costs can greatly increase the total cost of a loan. If you want to avoid paying more than you borrow, avoiding this type of interest is best.

How capitalized interest works on student loans

Let’s start with how a student loan works. When you take out a student loan, you’re charged interest. The interest charges are essentially the cost of the loan, as most lenders won’t let you borrow money for free!

The total cost you pay for a loan is determined not just by how much you borrow but also by the interest rate. A higher interest rate will increase the overall cost of a loan.

Additionally, the time you take to repay the student loan will affect your total costs.

Capitalized interest on student loans can further increase overall costs. As interest increases, your monthly payment goes up, making it even harder to pay back your loans.

An increased principal increases the total amount you must pay back over time. Thanks to the effects of compounding on that principal and interest. Yup, it’s one of the examples of compound interest!

Capitalized interest vs accrued interest

You might be wondering if capitalized interest is the same as accrued interest. While they’re related, they’re not the same.

Capitalized interest is the accrued interest that your student loan lender adds to your principal amount when the interest goes unpaid.

Accrued interest is interest that increases with time. Essentially, it’s the amount of interest that has grown since your last payment, but you haven’t paid it yet.

If you don’t pay the interest on your loan as it accrues, your lender can add the accrued interest to the principal, resulting in capitalization.

For instance, interest could accrue while you are in school. Thanks to deferment periods, you don’t have to pay it back until you graduate.

However, this means your lender can add your unpaid interest to your total loan balance at the end of the deferment period. They can also charge you interest on the new balance.

Capitalized interest example

As a capitalized interest example, let’s talk about it works on student loans work. Say you take out a student loan for $20,000 at 5.8% for ten years. You defer payment through 4 years of college and a six-month grace period.

The interest accrues and capitalizes, and now $20,000 is over $34,000. It’s likely to be even more when you factor in fees. The capitalized interest alone would be over $7000.

Interest can impact your life in the long term. It can make it harder to accomplish your other financial goals if you have the addition of unpaid interest. In my experience, getting out of debt is much harder than avoiding it in the first place.

Expert tip: Don’t skip over reading your loan agreement

Interest capitalization can happen on both federal student loans and private loans. To avoid it, be sure to carefully read your loan agreement so you know when interest will be capitalized. Do this regardless of whether your loan is federal or private.

How do you end up with a capitalized interest student loan?

Interest capitalization on your student loans can happen for several different reasons. Generally, interest capitalizes after a period of not paying the loan’s balance.

With federal loans, interest capitalizes when:

• The grace period of your unsubsidized loan ends
• When you consolidate your loans
• When you leave an income-based repayment plan like Pay As You Earn (PAYE)
• During forbearance or after a period of deferment (for unsubsidized loans after deferment, not subsidized)

For example, let’s say you take out an unsubsidized student loan over four years. The loan is for $27,000 with an interest rate of 4.53%. After your four years are up and the end of the grace period, six months after you graduate, you will have thousands of dollars in unpaid interest.

That means while you thought your loan was only $27,000, it’s now over $30,000. And don’t forget—you now have to pay interest on that higher balance.

How can you avoid a capitalized interest student loan?

The average cost of a four-year college is around $26,000 a year, according to Education Data Initiative, you might have to take out some student loans to cover costs.

Of course, no one wants to pay more than they have to. Capitalized interest on student loans will definitely increase your payments.

The good news is there are many ways to avoid capitalized interest on your student loans altogether.

Pay student loan interest while you’re in school

Your education is a long-term asset, and student loans may be necessary to help you earn your degree. However, that doesn’t mean your loans should define your future. If possible, start paying off your student loans while you are still in school.

Not everyone can afford to make loan payments while in school. This is why loan deferment and post-graduation grace periods exist.

However, one of the easiest ways to avoid capitalized interest is to pay your student loan interest costs even while the loan is deferred. Try to find a way to pay your interest while in school. You can avoid hefty costs when you graduate.

Make extra payments

While it might not be possible to pay off your loans while you are still in school, you can make extra payments later. Once you’re graduated and financially secure, you can lower your interest costs by paying down your balance with extra payments.

Paying extra doesn’t necessarily avoid the interest, but it does help reduce your loan balance after adding capitalized interest. The more you can lower your loan balance, the less you’ll pay in interest charges over the life of the loan.

For example, I paid off my last car loan over two years early by making extra principal-only payments every few months, which saved me over $1,000 in interest.

I got the loan with a higher interest rate than I was hoping for, so I knew I needed to be aggressive with repayment to lower the overall cost of my vehicle. Each time I found myself with extra cash, I made an extra payment on the car because I really wanted to get out of my car loan.

Additionally, if you can make any extra payments while in school, doing so can only help. If you begin to make extra money from a job or find that you have some cash available, using it to pay off student loan interest that could be capitalized is a smart idea.

Pay tuition without student loans

If you’re lucky enough to be able to, avoid student loans altogether.

Instead, you can use grants, scholarships, and work-study to pay for school. Researching alternatives to loans before going to college may be helpful.

I was lucky enough to graduate college without any student loan debt, thanks to a combination of education savings and scholarships. I chose a school that offered a range of merit-based scholarships and was known for awarding high-dollar scholarships to students with similar extracurricular resumes and grades to mine.

You may also choose to start working and going to school over a longer period of time.

Use passive income to get ahead

While you might be quite busy with your classes for the next few years and focusing on your studies is important, you can still make money. Passive income can be a great alternative to working a job while in school full-time.

How does it work?

Passive income generally requires some work to set up. After setting it up, however, your passive income stream generates revenue with little to no work from you.

There are a lot of passive income ideas for students that you can try out, including renting out your car, textbooks, and other belongings. It will help your financial situation and eliminate student loans and interest.

Know when interest will capitalize

Regarding student loan interest, a proactive approach is generally better than a reactive approach. One of the best ways to avoid capitalized interest on your personal balance sheet is to know when interest will capitalize and keep yourself out of those situations.

I suggest contacting your loan servicer or provider and asking them directly what would lead to interest capitalization. Loan agreements can vary, so situations that capitalize interest for a friend might not apply to your loan.

Going straight to the source will tell you when your interest might capitalize.

Additionally, it will tell you how you can stay away from these situations.

Negotiate with your loan servicer

Speaking of reaching out to your loan servicer, you can always try to negotiate your loans with your provider.

Whether you have federal or private student loans, you may be surprised how many interest repayment options might be available to help you avoid capitalized interest. Many providers are especially willing to work with you if you’re struggling financially.

Remember, the worst outcome that can happen is your loan servicer saying no.

Refinance or consolidate loans

A word of caution: refinancing or consolidating your loans may trigger capitalization of outstanding interest. This might not be a big issue if you snag a great rate on your new loan because you’ll save enough to cover the additional balance.

However, if your rate isn’t significantly lower, you may need to pay off outstanding interest before refinancing. Paying the lump sum of your currently owed interest before refinancing means there won’t be any outstanding interest to capitalize when you refinance or consolidate.

Get a part-time job to pay loans

Do you have some extra time around your studies? You may want to get a part-time job to use exclusively to pay your student loan interest. Depending on how much you’ve borrowed, your part-time job may not need to be a huge time commitment to help you avoid interest.

Additionally, a part-time job in your preferred industry (or even an online part time job) could help you land a full-time career after graduation—which in turn helps you avoid deferment and capitalized interest charges.

In college, I knew several people who used their part-time jobs to help pay for college and advance their future careers.

For example, a friend of mine majored in finance and worked part-time as an accounts receivable clerk at a local business.

After graduating, they had both their degree and their part-time work in accounting to help them land a high-paying accounting job. They could immediately start paying their student loans without worrying about capitalized interest from the grace period.

Why am I paying capitalized interest?

You might be paying this cost on your student loans for a few reasons. It’s important to carefully go over your loan terms so you know what triggers will cause interest to capitalize.

Some of the most common reasons you might pay these costs include:

• You’ve reached the end of your post-school grace period.
• You’ve accrued interest during a deferment period or forbearance, which is added to your balance at the end of the period.
• You switched repayment plans, and unpaid interest was capitalized.
• Your income increased, and you no longer qualify for an income-driven repayment plan.

What are the rules for capitalized interest?

The exact rules can vary based on your student loan agreements.

For example, your loan agreement might capitalize interest if you enter a forbearance period. The best way to learn the rules of your loans is to talk to your loan servicer and ask which events will trigger interest capitalization.

Articles related to interest and student loans

Did you find this information about student loans and interest helpful? Then read these posts to find out more!

• Should You Pay Off Student Loans Or Invest?
• Key Tips For College Student Credit Card Debt
• Balancing School And Work Plus Financial Tips For Every College Student
• How Do Student Loans Work?

You can minimize your interest costs with some preparation

If you want to become debt-free and pay off your student loans, one of the things you can do is avoid interest capitalization. Pay off your loans as often as you can to help with this.

Student loans are unavoidable for many students, but that doesn’t mean you should have to pay more than you agreed upon. The easiest way to pay off your student loans is to avoid extra costs, especially capitalized interest.

If, for some reason, you need to pause payments, you can use a student loan calculator to find out how much you will owe if you let the interest capitalize. It can help you decide if it’s worth letting the interest pile up.

It may seem challenging, but with some guidance and planning, you can avoid capitalization and get to work paying off your principal balance. Want to learn more? Our free 3-course bundle on how student loans work can guide you in the right direction.

The post What Is Capitalized Interest On Student Loans? appeared first on Clever Girl Finance.

The credit card industry is definitely a lucrative one. And that doesn’t come as much of a surprise, considering most of us are walking around with a credit card in our wallets. But how do credit card companies make money?

Credit card companies make the most profit from interest charges and other fees. In fact, In 2022 alone, U.S. credit card companies made $130 billion off of consumers. But if you use credit cards wisely, you can often avoid paying these at all!

It all starts with learning the specifics of how credit card companies make money. We’ll be answering that question in this article, as well as sharing a few tips on how you can save money on credit cards.

Types of credit card companies and how they work

Before we dive into how credit card companies make money, let’s talk quickly about what they are and how they operate.

How a credit card company works depends on what kind of company it is. There are two main types of credit card companies: issuers and networks. Let’s learn about each type:

Credit card issuing bank

A credit card issuer is generally a financial institution that issues your credit card and who you pay your bill to each month. Examples of big credit card issuing banks include Capital One, Chase, and Wells Fargo. Smaller credit card issuers are out there too—for instance, even your local credit union.

Credit card network

A credit card network processes the credit card transactions. Major credit card payment networks include Visa, Mastercard, Discover, and American Express. And in the case of Discover and American Express, the companies act as both the card issuer and card network.

Both of these company types are involved with all the credit card purchases you make. When you use your credit card, you’re borrowing money from the credit card issuer. The card network acts as the middle person to process the transaction.

How do credit card companies make money? 3 ways

Credit card companies make money in more than one way. So what are at least two ways credit card companies make money?

There are actually three main ways when it comes to how credit card companies make money. They include:

1. Interest charges

When you use your credit card, you’re borrowing money from a financial institution. If you don’t pay off your balance in full at the end of the statement period, your balance begins to accrue interest.

Credit card companies make the most profit from interest, particularly when the interest grows and compounds. Remember that $130 billion figure we mentioned in the beginning—the amount credit card companies charged consumers in 2022? Well, $105 billion of that came from interest alone.  

Unfortunately, this doesn’t come as much of a surprise. According to Experian, the average credit card balance rose to $5,910 in 2022. 

Furthermore, the average annual percentage rate (aka APR, or interest rate) on credit cards has recently reached record levels of over 24%. You can keep tabs on the latest figures through Investopedia.

That means the average American is carrying a relatively high balance, and paying a high APR on it.

2. Card user fees

Beyond interest charges, credit card companies also make money on the fees they charge cardholders. Here are a few of the common fees they charge:

Annual fees

Many credit cards don’t require an annual fee at all. However, companies often charge these on cards that come with significant sign-up bonuses or user perks such as cash-back and miles. 

The average credit annual fee is about $94. But keep in mind that high-fee premium cards bring this average up.

Balance transfer fees

A balance transfer is when you transfer the balance of one credit card to another card, usually to get a lower interest rate. When you transfer the money, you often pay a balance transfer fee. These fees often range between about 2-5% of the amount you’re transferring.

Cash advance fees

A cash advance is when you withdraw cash from your credit card account. It’s similar to taking out a loan, but you’re simply borrowing against your credit card balance. In addition to the interest you pay on these advances, many companies also charge a fee. 

These costs can quickly mount, since the average cash advance fee is 5% of the amount you withdraw. 

Late payment fees

How do credit card companies make money from late payments? Well, when you don’t pay your credit card bill by the due date (or at least the minimum payment), you’ll usually be hit with a late fee. In 2022, the average fee for late payments was roughly $32, and U.S. consumers paid a total of $14.5 billion in late payment fees. 

While credit card companies make the most profit from interest by far, late fees take second place on the consumer side of things.

Foreign transaction fees

Foreign transaction fees may be charged on transactions made in a foreign currency or through a foreign bank. This fee is meant to cover the costs associated with currency conversion and processing payments through global networks. 

If you’re a frequent traveler, it’s worth looking for a credit card that doesn’t charge foreign transaction fees.

3. Merchant processing fees

In addition to the fees they collect from consumers, credit card companies also collect money from the merchant or retailer who accepts credit cards. These fees, known as interchange fees, cover the cost of processing the transaction. Often, the profits are split between credit card issuers and networks.

In 2022, the nation’s six biggest credit card companies collected a combined $31.9 billion in interchange fees.

Sometimes, small businesses charge an extra fee to use credit cards, and this is why. It costs them more to accept credit cards, so they have to weigh whether they can afford it without passing on the costs. 

Expert tip: Always read the fine print for your credit card

When you get a credit card, it can feel easier to just throw away that huge terms and conditions sheet that comes in the envelope. But the last thing you want is to be blindsided by unexpected fees. So take the time to understand the terms you’re agreeing to!

For instance, research what late payment fees and interest charges you may face if you miss a credit card payment. Before you travel, make sure you’re aware of any foreign transaction fees.

If you’re trying to use your credit card to get money at an ATM, understand what cash advance fees you’ll face for the privilege. And if the card is subject to an annual fee, keep track of when it will renew.

Knowledge is power, so knowing the terms of your credit cards will help you maximize the value you receive from them.

How to reduce credit card costs

There’s no doubt that credit card companies make a lot of money from consumers. But there are plenty of ways to reduce the amount you’re paying to credit card companies.

In fact, if you use your credit cards responsibly, none of your money has to go to credit card companies at all.

Pay your balance in full every month

The best way to save money on your credit cards is to pay your balance in full every month. When you do this, you don’t have to worry about paying interest. You’re only paying back the amount you actually borrowed. 

As an added bonus, paying off your balance doesn’t just help you save money on interest. It also reduces your credit card utilization, which can boost your credit score.

It’s all about using credit cards wisely.

Pay your bill on time each month

Another way to avoid giving your money to credit card companies is to pay your credit card bill on time each month. Doing so can help you to avoid late fees and maintain good credit.

And if you’re having a difficult time remembering to pay your bill, you can set up an automatic payment, so you never have to worry about it. (Although even if you set up autopay, make sure to review your history periodically to make sure your purchases look right.)

Negotiate your interest rate

Credit card interest rates aren’t set in stone. If you find that a lot of your monthly payment is going toward interest, call your credit card company and negotiate a lower rate.

It won’t always work, but it’s worth a shot. Here’s a script that you can use on your phone call.

Search for cards with no balance transfer fees

If you’re transferring your balance to help avoid paying interest, shop around for a card with no balance transfer fees. Depending on the size of your balance, this could save you a considerable amount of money.

Negotiate your annual fees

If you have a credit card that charges an annual fee, you may be able to negotiate with them to waive or reduce your annual fee. Never hurts to ask!

It’s smart to always weigh the annual fee against the rewards you’re getting from the card. If the fee amounts to more than the value of your annual rewards, it might be best to downgrade the card to a fee-free version, or close it.

Have an emergency fund to avoid cash advances

A cash advance is typically only used in the case of an emergency where you need cash immediately and don’t have another way to get it. And while these situations are often inevitable, having an emergency fund in place in a traditional bank account can help you save money. 

Rather than paying a cash advance fee and interest, you can earn interest on your emergency fund while it sits in a savings account, and then it’s there to protect you when you need it. 

Ask for a late fee waiver

If you lost track of time and got slammed with your first late fee, don’t despair! Many credit card companies will gladly waive them as a one-time courtesy. It helps if you have a history of on-time payments and a good relationship with the issuing bank.

Check your credit card statement regularly

Many of us have had a situation where we check our credit card statement, only to find something that shouldn’t be there. Sometimes it’s an honest mistake, and the credit card company fixes it, but sometimes it’s a fee that we weren’t expecting.

And in the worst-case scenario, it’s a case of identity theft where someone has used your credit card number. Checking your statement regularly can help ensure you aren’t paying for any fees or purchases that you shouldn’t be.

How do credit card companies make their biggest profits?

Credit card companies make the most profit from the interest charges they levy on cardholders. Even though credit card companies have a variety of revenue streams, this one stands out above the rest.

Thanks to sky-high annual percentage rates, credit card companies can earn a lot of money from users who don’t pay off their balances. But you can hack the system and pay zero interest charges by paying your statement balance in full each month!

Why are credit cards so profitable to banks?

Thanks to the triple-whammy interest stream of interest, consumer fees, and retailer fees, credit cards can be quite profitable and lucrative for an issuing bank. Even when you factor in the credit card rewards they pay as user incentives, the banks still come out ahead in profits.

Do credit card companies make money if you pay in full?

Yes, credit card companies can still make money even if cardholders pay their full balances each month. So how do credit card companies make money if their customers are all financially savvy?

While they won’t earn interest or late payment fees from those who clear their balances on time, credit card companies still have other revenue streams. These include the transaction fees they charge to merchants, annual cardholder fees, balance transfer and foreign transaction fees, etc.

What are at least two ways credit card companies make money?

Credit card companies use various strategies to generate revenue. But when you look only at their main sources, how do credit card companies make money?

The top two ways credit card companies make money are:

1. Interest charges
2. Merchant fees

This means that the biggest sources of credit card company income are split between consumer and retailer charges.

Now you know how credit card companies make money

Credit card companies make billions of dollars each year, primarily from their customers. Unfortunately, many people don’t realize just how much of their hard-earned money is going to their credit card company.

If you use a credit card, it’s important that you understand the advantages and disadvantages. It’s also important that you plan your finances and budget accordingly so you can pay off your credit card balances as soon as you can.

Luckily, following the tips above can help you to avoid unnecessary interest and fees and keep more of your money for other financial goals.

The post How Do Credit Card Companies Make Money? 3 Ways appeared first on Clever Girl Finance.

How do student loans work? If you’re seeking the answer to this question, you’re not alone. Student loans can be a useful way to fund your education and there are many types of student loans available for undergraduate students.

Many students look to loans as a solution to their cash flow issues, but it’s important to understand exactly how student loans work.

Especially since 43.6 million borrowers currently have federal student loan debt, and the average balance is $37,718. Finding the right product for you at the lowest cost can make a huge financial difference.

So, how do college loans work? What types of loans are available? And how do student loan interest rates work?

In this article, we’ll take a closer look at how student loans work, along with their interest rates, repayment options, limitations, and more. Once you’re armed with our guide, you can move forward with confidence.

How do student loans work?

Student loans are a type of loan available for borrowers to pay for education. You can secure student loan financing from the government or through private lenders. In either case, you’ll usually be expected to repay the loan (with interest on top) following your studies.

When you take out a student loan, the process will depend on the type of loan you are pursuing. But whether you are taking out federal or private loans, the purpose remains the same: funding your education.

Keep in mind that the loans you take out will need to be paid back within a specified time frame. Not only will you have to repay the loans, but you’ll also have to pay any interest attached.

In many cases, you will not need to start making loan payments until after your graduation. Plus, some lenders will even give you a grace period of a few months between your graduation and the start of your repayment.

That said, it’s important that you’re clear on your specific loan terms before signing on the dotted line of your agreement. This includes your loan’s interest rate and the repayment requirements.

Most common uses of student loans

There are a variety of expenses that college students generally face. How do student loans work when it comes to covering them all? Let’s look at a few common categories of expenses that students might use their loan money for.

Tuition and fees

This, of course, is the “big one.” With tuition costing thousands (or even hundreds of thousands) of dollars over your college career, loans can make it possible for you to get through the door in the first place!

Room and board

Whether you’re bunking up in a dorm or renting a spot off-campus, student loans can help you afford housing near your school. There’s nothing more quintessentially “college” than a cozy study pad! Plus, the “board” in “room and board” means your loan can cover things like your meal plan at the cafeteria.

Textbooks, supplies, and tech

Ever cringed at the price tag on a textbook? We’ve all been there. Student loans can help you get the books and other school supplies you need. If you don’t already have a good computer, you can use your loans to set yourself up with the technology you need to get your work and research done.

Other living expenses

Life doesn’t pause just because you’re hitting the books. Student loans can lend a hand with everyday living expenses, from groceries to bus fare. Good budgeting tips for college students will help you make the most of your money!

Student loans vs. scholarships and grants

As you dive into student loan financing, note that loans are very different from scholarships and grants. The main difference? You don’t have to repay scholarships or grant funds. But you will have to repay the student loans you take out, plus interest.

Scholarships

Scholarships are merit-based awards given for achievements, skills, or sometimes just for being you. They can come from your school, private organizations, or local businesses who want to support students in their community.

Grants

Grants are similar, but they are usually need-based instead of merit-based. Federal and state governments, as well as private organizations, may offer grants to students, with their eligibility based on their financial situation.

Of course, the ideal solution is to focus on scholarships and grants to fund your education. You might even be able to get a full-ride scholarship that covers all your college costs!

However, it’s more likely to get a partial scholarship that contributes a smaller amount toward your education. Thus, many recipients also need student loans to cover any gaps.

Types of student loans available

How does a student loan work from a logistical standpoint? To answer this properly, we’ll have to get into the different types of student loans.

The two main student loan options available are federal and private funding. Let’s take a closer look at both, so you know exactly how student loans work.

Federal student loans

Most people who get student loans start by applying for federal loans. Federal student loans often offer more appealing loan repayment terms. And in general, the interest rates are more affordable compared to private student loans.

That being said, there are different types of federal student loans you should be aware of:

1. Direct subsidized loans

A direct subsidized loan is made directly by the U.S. Department of Education. The government will offer you one of these subsidized direct loans if you can demonstrate a financial need.

How does this work? The government will pay all of the accrued interest on your student loans until six months after you leave school. You’ll then start making your principal payments and any applicable interest following this initial six-month period.

2. Direct unsubsidized loans

Direct unsubsidized student loans are available for students who aren’t able to demonstrate a financial need. They’re available for undergrads, graduates and professional students.

The main difference between subsidized and unsubsidized direct loans is that interest accumulates from the beginning of an unsubsidized loan. However, these loans still offer a low, fixed interest rate and flexible repayment terms.

3. Direct PLUS loans

With Direct PLUS loans, parents of dependent undergraduate students help cover the cost of their child’s undergraduate tuition. You’ve probably heard this type of loan referred to as a “Parent PLUS loan.” They can be a great option for parents who want to invest in their child’s education.

A similar Grad PLUS loan can also be an option for graduate or professional students who need loans to cover their education expenses.

Applying for federal student loans

If you want to take out federal student loans, find out if you are eligible through the Free Application for Federal Student Aid (FAFSA).

With FAFSA, you’ll fill out your financial information and your parents’ financial information. After looking at your numbers, the school will send you an award letter highlighting the type of financial federal aid you’re eligible for. This could include scholarships and grants, as well as student loans.

Private student loans

Private loans can help you make ends meet during school if you don’t have access to federal loans or have already reached your cap.

How do college loans work from private lenders? Well, it’s pretty similar to taking out any other type of loan. You’ll borrow money from banks, credit unions, or online lenders, then repay it according to whatever terms are in your contract.

Eligibility for private student loans is often based on creditworthiness  and a credit check will determine this. Since many college students haven’t established credit yet, they usually need a cosigner with good credit who is willing to help them get the loan.

Potential downsides of private student loans

If you work with a private lender, you may have less flexibility in terms of repayment. While the federal government might be willing to work with you on forbearance or a forgiveness plan, private lenders are less flexible.

The terms of a private student loan can also vary dramatically. You may need to undergo a more stringent application process with a cosigner to take out private student loans. They usually look at things like your (or your cosigner’s) credit history and credit score.

The biggest downside of a private student loan is you may face higher interest rates. Since private student loans can have variable interest rates, this could be as high as 18%! Beyond that, you might be required to start making payments while you’re still in school.

With that, it is important to shop around before committing to a private student loan lender.

How much can you borrow in student loans?

There is a limit to how much money you can borrow in federal student loans. Here’s the breakdown:

Independent undergraduates

Independent undergraduates may be able to borrow up to $12,500 per year in federal student loans. Only $5,500 of that can be subsidized.

Dependent undergraduates

Dependent undergraduates may be able to borrow up to $7,500 per year in federal student loans. But only $5,500 can be subsidized.

Graduate students

Graduate students may be able to borrow up to $20,500 per year in subsidized loans.

Student loan limitations and key considerations

There are some other limitations to consider. First, with federal loans, the amount you borrow cannot be more than the cost of attendance determined by your school. Your school’s financial aid office should have this information.

Additionally, you are only eligible to take out federal student loans for 150% of the published timeline for your degree. For example, if you’re in school for more than 6 years to complete a 4-year degree, you wouldn’t be eligible for additional student loans.

If you’re unable to afford school with federal student loans alone, you’ll have some flexibility to borrow more money through private lenders. Each lender will have different limitations on how much you will be able to borrow.

Expert tip: Don’t borrow more than you need

Even if you qualify to borrow more money than you need to survive your years as an undergraduate, you should be careful about borrowing more funds than you actually require. The more debt you have, the more difficult it will be to repay down the line.

Enjoy your time at college, but maintain the mindset that student loans aren’t free money. It’s more like borrowing money from your future self. So if you can live in a cheaper apartment or buy textbooks secondhand, future you will appreciate it!

How does student loan interest work?

When it comes to interest, how do student loans work? Three key components will determine how much you pay back overall when you take out a student loan.

The principal

When you take out a loan, you’ll be required to repay those funds in full (unless you qualify for special circumstances). The principal on a loan is the base number that you owe to repay the lender without any interest.

Let’s say you borrow $5,000 a year for 4 years. That means your principal loan amount would be $20,000 total, before any interest is factored in.

The interest rate

Next, how does student loan interest work? Essentially, the loan’s interest rate is the premium a lender charges for allowing you to borrow the funds. The rate is applied to your principal balance.

Interest rates are always fluctuating, so there’s no simple answer for how much interest you can expect to pay. However, as of 2023, the average student loan interest rate was 5.8% among all existing borrowers (federal and private).

Unfortunately, interest payments can add up quickly. For one thing, interest on your loan may be capitalized, meaning that unpaid interest is added to your loan principal and compounds. In this scenario, debt quickly mounts.

The loan term

The final piece of the puzzle when it comes to understanding student loans is the length of the term.

With federal loans, the standard repayment term is ten years, but it can be extended to 25 years. Private lenders may imitate the ten-year term, set shorter terms, or allow longer spans of 20-25 years.

But remember, the longer you take to pay off your loans, the more interest you’ll accrue over time.

Example of how student loans work

The three numbers above determine how much the total loan costs. But what do they look like in real life?

For example, let’s say you took out $20,000 in student loans over the course of your education with a ten-year term and a fixed interest rate of 6%.

With that, you’d have a monthly payment of $222. If you repaid the loan in ten years, it would cost you $26,645.

As you can see, the interest on your loan can add up quickly.

What are your student loan loan repayment options?

So, how do student loans work when you’re planning how to pay back the money you’ve borrowed? You’ll need to create a repayment plan. As you weigh your options, it’s important to consider all the alternatives available to you. So let’s explore them now!

Loan forgiveness

There is an opportunity to have your loans forgiven if you took out federal student loans. The federal government offers several student loan forgiveness plans. Here are the most popular options:

1. Public Service Loan Forgiveness (PSLF)

The PSLF will forgive the remaining balance of your student loans if you make 120 qualifying monthly payments and work full-time for a qualified employer.

If you work for non-profit organizations or a government agency, then it’s possible that you qualify. Be sure to confirm your employer offers this program and that you qualify for it before assuming you’ll get it.

2. Teacher Loan Forgiveness

The Teacher Loan Forgiveness program is designed to reward teachers who work full-time in low-income elementary schools, secondary schools, or educational services agencies.

You may apply to have $17,500 of your federal student loans forgiven if you teach for five consecutive years in a qualifying school.

If you are considering either forgiveness option, find out more about the qualification details. Your loan officer will help you understand if you meet the forgiveness requirements.

Payment plans

The federal government offers a variety of repayment plans. The best option for you will depend on your personal situation. You can check out a loan calculator on the federal government’s website to explore your options further.

Here are the repayment options available for federal loans:

1. Standard repayment plan

With a standard repayment plan, you’ll pay the fixed amount you owe on your loan each month. If you keep up with these payments, you could pay your loan off in 10 years.

2. Direct consolidation loans

With a direct consolidation loan, you’ll repay your loan within 30 years. This type of loan works by combining two or more federal loans into a new loan. This new loan has a fixed interest rate based on the consolidated loans’ average rate.

3. Graduated repayment plan

A graduated repayment plan works on the basis that when you start your career, your income might be lower than after a few years of experience. The graduated repayment plan recognizes that and sets up the monthly payments accordingly.

Typically, you’ll start by making smaller payment amounts. After two years, your monthly payment will increase. Your payment will increase further every two years until you’ve repaid the loan at the ten-year mark.

4. Extended repayment plan

An extended repayment plan is suitable if your income doesn’t support a high monthly student loan payment. This option allows you to stretch out your loan obligation. Instead of repaying your loan in 10 years, you’ll have 25 years to repay the loan.

Although your monthly payments will be lower, this option will cost you more interest over the loan term.

5. Pay as you earn repayment plan (PAYE)

With PAYE, you’ll make monthly payments equal to 10% of your discretionary income. However, the payment would never exceed the amount you would have paid under the standard repayment plan.

If there is a balance left on your loan after 20 years, your debt will be forgiven. However, you might have to pay income tax on the forgiven amount.

6. Income-based repayment plan (IBR)

This is also known as the income-driven repayment plan. A large student loan payment can dramatically impact your monthly budget. You might even have trouble paying for the essentials with a student loan taking a large bite out of your income.

The income-based repayment plan will allow you to cap your payments at 10% of your discretionary income. This can be a relief if you’re struggling to put food on the table while making your student loan payments.

This is quite a popular option, so we break down everything you need to know about income-driven repayment plans here.

7. Income-contingent repayment plan (ICR)

With the income-contingent repayment plan, you’d pay the lesser of the following two options. Either you’ll make a monthly payment of 20% of your discretionary income, or it’ll be the amount you’d pay on a 12-year fixed repayment plan.

What to do if you can’t repay your student loan

For many college graduates, you only have a six-month grace period before you have to start repaying your loan. Even if you haven’t found regular work by this stage, you’ll often need to start paying back your loan regardless.

But how do student loans work if you don’t have the money to pay? Here are some things you can do:

Contact your loan provider

The first thing you need to do is to contact your loan provider. Being honest about your situation is the best way to learn about available options without getting deeper into financial difficulty. Find out if you’re eligible for any forgiveness plans, or otherwise, learn what options are available to you.

Apply for student loan deferment

Student loan deferment is a temporary pause in your student loan payments. Deferment is typically granted for specific reasons, such as returning to school, economic hardship, or unemployment.

You’ll have to reach out to your lender and complete a deferment application. It will usually ask for details about your circumstances and possibly supporting documentation to demonstrate your need.

If you’re approved, your loan servicer will specify the duration of the deferment period and any other conditions. For instance, interest may continue to accrue and add to your loan.

Switch to an income-driven repayment plan

Switching to a flexible repayment plan based on your income may be a possibility. Meaning the lower your income, the lower your student loan repayments. Bear in mind that it might take longer to pay back your debt if you’re not able to tackle your debt aggressively.

Tackle your budget

By slashing your expenses and increasing your income, you may discover there’s more room in your monthly budget to repay your student loans on time.

It’s never too early to learn about budgeting. In fact, using a college student budget will ensure you don’t borrow more money than you need during your studies.

Consider refinancing

Beyond repayment plans, student loan refinancing is also an option. By refinancing, you would take out another loan to cover your student loans. With your new loan, you would find a lower interest rate and terms that suit you better.

It is important to note that student loan refinancing is not the best option for everyone. But if you have private student loans with a high interest rate, then it is something that you should consider. You can also check out more advice for student loans and the best loan resources.

Is it worth it to get a student loan?

This is a very individual decision. Student loans can be a valuable investment in your future, opening doors to better job opportunities and higher earning potential.

However, it’s essential to weigh the costs (including interest) against the potential benefits of your chosen education path. Research the average salaries in your chosen field and consider whether you’ll be able to live (and pay your loans) comfortably.

How are student loans paid back?

Student loans are typically repaid in monthly installments. You’ll work with your loan servicer to determine a repayment plan that fits your financial situation.

How do you actually get student loans?

To get student loans, start by completing the Free Application for Federal Student Aid(FAFSA). The FAFSA determines your eligibility for federal student loans (and grants, too!). Once you receive your financial aid offer, you can accept or decline the loans.

If federal loans aren’t enough, you’ll need to complete separate applications with private lenders to get the remainder of the funds you need.

Why is it so hard to pay off student loans?

High tuition costs, constantly accruing interest, and unpredictable job markets can all make it difficult for borrowers to pay off their student loans. And life just likes to throw curveballs sometimes!

For many who are struggling, the key lies in understanding their available repayment options, budgeting effectively, and looking for ways to increase their income. Most importantly, don’t get discouraged or give up.

Articles related to debt and student loans

If you enjoyed this article on how student loans work, check out this related content:

• Should You Pay Off Student Loans Or Invest?
• Key Tips For College Student Credit Card Debt
• What Is Capitalized Interest On Student Loans?
• How To Avoid Student Loans: 7 Key Ways
• Should I Refinance My Student Loans?

Now you know how student loans work, is it the right choice for you?

A college education can help you move forward in your career. But student loans can be a drain on your personal finances for years. So, if possible, seek out ways to avoid taking on any student loan debt.

If this isn’t possible, then be aware of all the available student loan options so you make the best choice for your specific situation.

Student loans can be a good way to fund your education. Just make sure you fully understand student loans and their impact on your financial future before signing up.

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