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How do student loans work?

Key takeaways

  • Student loans allow borrowers to finance higher education expenses.
  • There are 2 main types of student loans—federal and private—each of which has different benefits and considerations.
  • Student loan repayment generally does not begin until after the student has graduated, though depending on the loan type, interest may start accruing before then.

With college prices reaching new heights almost every year, higher education may feel out of reach for many students. The average total cost of an in-state school was just under $24,030 in 2023-2024, and private universities were $56,190, according to The College Board.1 That’s anywhere from about one-third to three-fourths of the real median household income in the US.2 But still, 65% of recent college graduates say their education was worth the cost, according to the Fidelity’s 2023 College Savings & Student Debt Survey.

Student loans can help make higher education—and those steep prices—more accessible for students. But there are important fine details to understand.

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How do student loans work?

A student loan lets you borrow money to pay for higher education costs. You must eventually pay back what you borrow in monthly installments—plus interest and fees.

Student loans can be used to cover costs like undergraduate or graduate school tuition, as well as related costs like fees, books, and living expenses. The total amount of student loans you can take out usually depends on the estimated cost of attending your chosen higher education institution, minus any grants or scholarships you receive. You may also face annual and cumulative limits to the amount of federal loans you take out.

You generally don’t receive all of the money you borrow for a student loan at once. Instead, it is usually paid out each semester to your college or university. Typically, the institution will apply what they receive directly to tuition, fees, and room and board (for those living on campus). Then they give you whatever is left over to pay for other educational expenses you may have.

Unlike other types of loans, you typically don’t have to start paying back what you borrow immediately, provided that you are enrolled at least half of the time in school or you’re within the grace period (normally 6 months) after you graduated. Interest, however, may accrue during these times.

How does student loan interest work?

Student loan interest is usually calculated using a simple interest formula. This means that the interest rate of your loan is applied to the original amount you borrow (aka your principal). Student loan interest is calculated each day by multiplying your remaining principal by your interest rate factor (your interest rate divided by the number of days in the year).

Notably, student loan interest on federal student loans and most private student loans does not compound—meaning the interest you accrue is not added onto your principal when you don’t pay it. (Check out our guide on compound interest to learn more.)

Student loan interest capitalization

Student loan interest capitalization happens when outstanding interest you owe is added to the principal and used in future calculations of interest accumulation. Student loan interest capitalization only occurs in certain circumstances, such as after a period of deferment or forbearance, if you no longer qualify for or leave an income-driven repayment plan, or when your grace period ends after you graduate (for certain loans not managed by the US Department of Education).

Here’s an example: If you borrowed $10,000 at an interest rate of 4.99%, you will accrue approximately $499 in interest on your principal each year. If you’re not required to make payments until 6 months after you graduate from a 4-year program, you will accrue approximately $2,246 in interest over that time ($499 x 4.5, for 4 years of schooling plus a 6-month grace period).

If your student loan interest is capitalized once your grace period is over, the principal upon which all future interest accruals will be calculated becomes $12,246 ($10,000 + $2,246). Moving forward, you’ll start accruing about $611 ($12,246 x 4.99%) in interest each year—more than $100 more than you otherwise would rack up—because your initial interest capitalized.

Student loan interest and repayment

Student loan repayment may work a little differently than you’d expect, especially when it comes to paying off interest. With each payment you make, the money is first applied to any interest accrued since your last payment. The remaining portion of your payment is applied to your principal balance.

Because of this, it can take a while before your monthly payments start making a dent in your principal balance, especially if you accrued interest before you even graduated. However, if you make interest-only payments while you’re in school, you can reduce the amount of interest you pay overall. And you may be able to get ahead once you’ve paid off all of your interest and ask your loan provider to apply extra payments to your principal.

Types of student loans

There are 2 main types of student loans:

  1. Federal student loans issued by the government
  2. Private student loans issued by banks, financial institutions, and other non-governmental organizations

It's important to understand the differences between the 2 to make the best borrowing decisions for your financial needs.

Federal student loans

Available through the US Department of Education, federal student loans are loans from the federal government that you can use to pay for higher education expenses. Some of their benefits include:

  • Most federal student loans do not require a credit check, so you cannot be denied because you have poor or limited credit history.
  • Interest rates on federal student loans are set by Congress each year for the following academic year and are the same for all borrowers, regardless of credit history or loan size. These are also often lower rates than private student loan providers offer.
  • Lower-income individuals may qualify for subsidized student loans that the government covers interest payments on while you are in school at least half-time and through a 6-month post-graduation grace period.
  • There are no prepayment penalties, so you won’t be charged a fee for paying off a loan early.
  • You may be eligible for repayment plans based on your income—or, in certain cases, for your loans to be forgiven entirely.
  • You may be able to consolidate your federal loans, allowing you to maintain federal student loan benefits while also potentially lowering your monthly payment, getting access to more income-driven repayment plans, or extending the time to repay your loans. Refinancing loans with a private student loan provider may cause you to lose certain benefits.

One of the biggest limitations of federal student loans is that there are annual and aggregate maximums guiding how much you can take out. If the maximum falls below the amount it would cost you to attend school, you may choose to take out private student loans to make up the gap.

How to apply for federal student loans

To apply for most student loans, students must complete the Free Application for Federal Student Aid (FAFSA). Most international students cannot receive federal student aid.

How to pay back federal student loans

Depending on your loan type, you may be able to follow a few different kinds of repayment plans. Federal loans can typically be paid back over 10 or 25 years either with equal payments over those time periods or graduated payments—meaning they start smaller at the beginning of the repayment period and increase over time as you get older and your income (hopefully) increases.

Federal loans may also be eligible for income-driven repayment plans, which base their repayment schedules on a percentage of your discretionary income and promise full repayment within 20 or 25 years or forgiveness of any remaining balance at that time.

Private student loans

Private student loans are student loans offered by banks, credit unions, and other financial institutions. Unlike federal student loans, private loans do not have universal borrowing limits, interest rates, or repayment terms, and providers may deny borrowers based on their perceived credit worthiness. Private student loans may also be available to international students while federal student loans are not.

Each private lender sets its own rates, requirements, and terms. Because each private loan can come with different benefits and potential downsides, it’s important to carefully review the terms before signing.

How to apply for private student loans

Students apply for private student loans directly through the individual lender. The exact process will vary based on the provider.

How to pay back private student loans

Private lenders set their own repayment plans, but you can expect a monthly payment that gradually reduces the principal you owe over time. Some private lenders require you to begin repayment immediately after the loan is paid out. Others allow borrowers to wait until after graduation or leaving school.

What happens if you can’t pay back your student loans?

Not paying back your student loans can have serious consequences. If you miss enough payments, your loan may go into default, which would be reported to credit agencies and impact your ability to borrow in the future or lead to the government taking money from your wages, tax refund, or other governmental payments you’re eligible for.

If you are struggling to afford your student loan payments, it’s best to reach out to your loan servicer to explain the situation and ask for assistance. Or reach out to your employer to see if they offer a student loan benefit program. Check out Fidelity’s student debt help center to learn more.

Is there a better way to pay off student loans?

Use our student debt dashboard to evaluate repayment options.

More to explore

1. “Trends in College Pricing,” College board, accessed February 8, 2024 2. “Median Household Income,” US Census Bureau, accessed February 8, 2024.

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