Federal Student Loans: What Are They and How They Work
The federal student loan program has taken decades to get to where it is today.
If paying for college yourself isn’t an option, you’ve probably looked into alternative options like federal student loans. Federal student loans aim to increase access to education by offering financial aid and flexible repayment plans. They can help to make college possible for students who are facing financial hurdles toward furthering their education.
In order to fully understand the federal student loan program, it’s helpful to take a closer look at why it was started in the first place—and how it’s changed through the years. Before we dive into the specifics of how federal student loans function, let’s take a brief look at the history of the program.
History of the Federal Student Loan Program
The very first attempt by the United States government to offer student loans came in 1958 through the National Defense Education Act, a response to the perceived threat of the Soviet space program. In order to achieve scientific advances, the government wanted to get more students enrolled in postsecondary education and the NDEA offered a loan program to do so.
Shortly after that, student loans as we know them today had their genesis with the Higher Education Act of 1965. The Federal Student Aid program was implemented to help students achieve their goals of getting undergraduate, graduate, and professional degrees.
This was further refined in 1980, a year that saw HEA reauthorization, which resulted in the creation of PLUS loans. This gave parents the ability to borrow on behalf of their dependent students, which was later uncapped in 1992 to diversify the amount parents could take out in loans.
After developing the FAFSA application, short for Free Application for Federal Student Aid, the Federal Student Aid program now processes over 20 million applications a year—managing fund distribution at over 6,000 schools domestically. Currently providing over $120 billion in financial aid, the federal student loan program is the largest financial aid provider in the United States.
Federal Student Loans Available Today
Today, there are four main types of federal student loans under the William D. Ford Federal Direct Loan program. The U.S. Department of Education acts as your lender for these federal student loans and will assign you a loan servicer. Here are the four types of federal student loans currently available.
- Direct Subsidized Loans
- For eligible undergraduate students
- Must demonstrate financial need
- Direct Unsubsidized Loans
- For undergraduate, graduate, and professional students
- Not based on proof of financial need
- Direct PLUS Loans
- For graduate or professional students and/or parents of dependent undergraduate students
- Not based on proof of financial need, though a credit check is necessary
- Direct Consolidation Loans
- Offers the ability to compound your federal student loans into one
- Requires the help and approval of a loan servicer
How Did Private Student Loans Develop?
While federal student loan programs developed in the proceeding century and tend to get most of the attention, private student loans were also developing as a product around this time.
While banks have always been able to lend to students if they see fit, they are relatively small players in the student loan game. In 2013, the banks’ current outstanding funds represented around 3% of the total student debt in the United States. The country’s largest private student loan lender, Sallie Mae, was originally conceived as a government entity in 1972. It began privatization in 1997—a process that took until 2005 to complete—and set the framework for other student loan specific lenders to come, which together with traditional banks have funded about 14% of the outstanding student loan debt.
Student Loan Debt Today
In recent years, the amount of federal student loan debt owed by Americans has grown considerably. A study from Pew Research Center shows that at the end of March 2019 Americans owed a combined $1.5 trillion in student loan debt, more than twice as much as they owed just ten years before.
At the same time, the percentage of student loans the federal government is subsidizing has been dropping. From 1998 to 1999, 60% of Direct Loans (or Stafford Loans) were subsidized, compared to the 29% of Direct Loans from 2018 to 2019.
Key Differences Between Private and Federal Student Loans
There is no right or wrong choice when deciding between private and federal student loan programs, though there are important differences to note before signing on the dotted line. Here’s what you should know.
1. Payment Timing
One key difference between federal and private student loans is the terms of repayment. Payments for federal student loans typically begin after you graduate or change your enrollment status to part-time, or stop attending school. Payments for private loans typically begin immediately after you receive the funds for the loan. There are some private student loans, such as Sallie Mae’s Smart Option Student Loan, that allow you to postpone payments, but don’t rely on this being standard across all private lenders.
2. Interest Rates
Federal student loans have a fixed interest rate while private loans have either fixed or variable interest rates. The fixed-rate on federal student loans can often be lower than that of a private student loan and significantly lower than the interest rate on a standard credit card. With a private student loan, your interest rate is determined largely by your credit.
While fixed interest stays the same throughout the duration of the loan, variable interest rates fluctuate with the state of the economy. This effectively makes a variable interest rate either higher or lower than that of a federal student loan, depending on your financial situation.
Keep in mind, fixed interest rates enable the borrower to map out exactly how much they’ll owe with added interest at the completion of their loan term. Variable interest rates are subject to change, so don’t offer the same opportunity to plan for exactly how much you’ll owe.
3. Repayment Plans
Federal student loans are popular for their flexible repayment plans, which include an income-driven repayment plan and the possibility to qualify for loan forgiveness. When it comes to private loans, you typically don’t have as many options. Private lenders generally require set monthly payments that continue on schedule until the loan is fully repaid.
History, Art & Archives. "National Defense Education Act." Accessed Jan. 2, 2020.
Office of Federal Student Aid. "About Us." Accessed Jan. 2, 2020.
U.S. Department of Education. "Federal Student Aid Policy: A History and an Assessment." Accessed Jan. 2, 2020.
Office of Federal Student Aid. "Loans." Accessed Jan. 2, 2020.
United States Congress. “Prepare Statement of John C. Lyons.” Private Student Loans: Regulatory Perspectives. Createspace Independent Publishing Platform. 2017, Page 36. Accessed Jan. 2, 2020.
United States Congress. “Prepare Statement of John C. Lyons.” Private Student Loans: Regulatory Perspectives. Createspace Independent Publishing Platform. 2017, Page 37. Accessed Jan. 2, 2020.
The U.S. Department of Treasury. "Lessons Learned From The Privatization of Sallie Mae." Page V. Accessed Jan. 2, 2020.
Pew Research Center. "5 Facts About Student Loans." Accessed Jan. 2, 2020.
College Board. "Trends in Student Aid 2019 Highlights." Accessed Jan. 2, 2020.
Sallie Mae. "Manage Your Student Loans." Accessed Jan. 2, 2020.