How a Federal Student Loan Works and Why the Balance Keeps Growing

Imagine buying a car by clicking "I agree" on a screen, with no test drive, no price on the window, no mechanic and an eighteen-year-old doing the signing. Imagine the dealer was the federal government, the car was a degree, and nobody in the showroom was allowed to ask whether the car would start.

That, with a few softer edges, is how millions of Americans first meet the federal student loan. They sign a promissory note in the spring of their senior year of high school or the fall of their first year of college, and for many of them the mechanism of the loan stays a mystery until the first bill arrives. Then comes the second surprise: they have paid for years, and the balance is higher than when they started.

That's not a mystery, and it's not magic. It is arithmetic. This post explains the machine, part by part, in the order a borrower meets it, with one worked example. I'll tell you where the conservative critique lands, and where the other side has a fair point. First, a little history, because the machine you use today was assembled in layers.

How Washington got into the lending business

1965: guaranteed loans. The Higher Education Act of 1965 created a program of federally guaranteed student loans. Banks and other private lenders made the loans, the government guaranteed them against default and paid the lenders subsidies. Over the years it became known as the Federal Family Education Loan program, or FFEL.

1972: Sallie Mae. Congress chartered the Student Loan Marketing Association, known as Sallie Mae, as a government-sponsored enterprise. Its job was to buy student loans from banks, so the banks would have fresh money to make more. If you know how Fannie Mae and Freddie Mac work in the mortgage world, you know the idea. Sallie Mae was later privatised: Congress passed a law in 1996 to wind down its government-sponsored status, which was completed in 2004, and in 2014 the company split into two, one that kept the Sallie Mae name and one that took over loan servicing, called Navient.

1993: Direct Loans. The Student Loan Reform Act of 1993, part of that year's budget law, created the Federal Direct Student Loan Program, in which the government lends the money itself, with no private bank in the middle. For years the two programs ran side by side and competed for schools' business.

2010: the banks are out. In the Student Aid and Fiscal Responsibility Act, known as SAFRA, which was attached to the reconciliation law that President Obama signed in March 2010, Congress ended new loans under the guaranteed program after June 30, 2010. Since then, all new federal student loans have been Direct Loans. The argument for the change was that the government was paying banks subsidies to take little risk, and the Congressional Budget Office scored the change as saving money, which Congress used for other priorities. The argument against it was that the government should not be the nation's largest student lender.

So today the lender is the U.S. Department of Education, and the borrower's account is managed by a private servicing company under contract. That is worth keeping in mind. When you hear "the government's student loan program," you are hearing about a bank that is also a regulator, a collection agency and a political issue.

How the loan works, part by part

The kinds of loans

For undergraduates, the main types are Direct Subsidized Loans, which are for students who show financial need, and Direct Unsubsidized Loans, which are available regardless of need. There are also loans for parents and for graduate students, and the rules for those have been changing, so check the Federal Student Aid website for the current terms before you borrow.

There are annual and lifetime limits. For a dependent undergraduate, the annual limits step up from $5,500 in the first year (no more than $3,500 of it subsidized) to $6,500 in the second and $7,500 in the third and fourth years, and the total across an undergraduate career is $31,000, of which no more than $23,000 may be subsidized. Those numbers are written in the statute, so confirm them before you rely on them.

The interest rate

Rates on new federal loans are fixed for the life of the loan, and they are set once a year by a formula in the law. Following the Bipartisan Student Loan Certainty Act of 2013, the rate for loans first disbursed in an academic year equals the high yield from the 10-year Treasury note auction in May, plus a fixed add-on, with a cap. The add-on is a couple of percentage points for undergraduate loans and higher for graduate and parent loans. That's why the rate on your loan depends on the year you borrowed.

Subsidized versus unsubsidized interest

This is the single most important difference to understand.

• On a subsidized loan, the government pays the interest while you're in school at least half-time, during the six-month grace period after you leave, and during certain deferments. Your balance doesn't grow until repayment begins.
• On an unsubsidized loan, interest starts accruing the day the money is disbursed. Nobody pays it for you. If you don't pay it, it piles up.

The origination fee

Before you receive a dollar, the government takes a percentage off the top. It's called an origination fee, a bit over one percent on federal loans for undergraduates, and it's set in law. For illustration, call it one percent: on a $5,000 loan, you receive $4,950 and owe $5,000. You pay interest on the whole $5,000.

Capitalization

Capitalization is when unpaid interest is added to your principal. From then on, you pay interest on the interest. It's the part of the machine that surprises people most. Under older rules it happened at several moments, such as when a grace period ended or when a deferment or forbearance ended. The Department of Education cut the number of capitalization events by a rule that took effect in 2023, and some events are fixed by statute, so check your servicer's current policy. But for unsubsidized loans the basic point stands: if you don't pay the interest while it builds, it's likely to be added to the balance at some point.

A worked example

This is a hypothetical. The numbers are invented and simplified, and they're meant to show the mechanism.

Meet Jordan, an imaginary borrower. Jordan takes out $5,000 in unsubsidized loans at the start of each of four years of college, at a fixed rate of 6 percent. That's $20,000 borrowed. Jordan pays nothing while in school. To keep the math clean, we'll treat interest as simple interest, accruing on the principal.

Interest during school. The first $5,000 sits for four years, the second for three, the third for two, the fourth for one. That's 4 plus 3 plus 2 plus 1, or 10 "loan-years" of $5,000.

• 5,000 times 0.06 is $300 of interest per loan-year.
• 10 loan-years times $300 is $3,000.

Interest during the grace period. Six months on the full $20,000.

• 20,000 times 0.06 times one-half is $600.

Total interest accrued before the first payment: 3,000 plus 600 is $3,600.

If that interest is capitalized when repayment begins, Jordan starts with a balance of 20,000 plus 3,600, which is $23,600. Jordan has not made a payment, and already owes 18 percent more than was borrowed.

On the standard ten-year plan, which is the default, Jordan pays a fixed amount each month for 120 months. At 6 percent on $23,600, the monthly payment is about $262. Over 120 months that comes to about $31,440. Jordan borrowed $20,000, and will repay roughly $31,440, of which about $11,440 is interest.

What if Jordan had paid the interest as it accrued? The balance at repayment would be $20,000, and the payment on a ten-year plan would be about $222 a month. The total interest, $3,600 paid along the way plus roughly $6,645 in repayment, would be about $10,245. Capitalization cost Jordan roughly $1,196 more, which is interest charged on interest. (This is a simplified comparison, but the direction is right.)

Why the balance can grow even while Jordan pays. Now suppose Jordan chooses an income-driven plan, in which the monthly payment is a percentage of income rather than a fixed schedule. Say that payment works out to $80 a month. Interest on $23,600 at 6 percent is 23,600 times 0.06, or $1,416 a year, which is $118 a month. A payment of $80 doesn't cover $118. The shortfall is 118 minus 80, or $38 a month, or $456 a year. Unless the plan waives the unpaid interest, which some plans do and some don't, the balance grows by $456 a year while Jordan makes every payment on time.

That's the mechanism behind many "I've paid for years and I owe more" stories. It isn't a trick. It's what happens when the payment is smaller than the interest.

The ways to repay

• Standard: fixed payments over 10 years, which costs the least in total interest.
• Graduated and extended plans: lower early payments or a longer term, and more interest overall.
• Income-driven plans: payment is a share of discretionary income, and any balance left after a set number of years (20 or 25, depending on the plan) can be forgiven. The percentages, years and details of these plans have been changed by statute, regulation and court rulings, so don't rely on a blog post, including this one, for the current terms. Go to the Federal Student Aid website.
• Public Service Loan Forgiveness: created by the College Cost Reduction and Access Act of 2007, it forgives the remaining balance after 120 qualifying payments for people working full time for government or certain nonprofits.

The bankruptcy rule

Most debts can be discharged in bankruptcy. Student loans are an exception. Under section 523(a)(8) of the Bankruptcy Code, a student loan is not discharged unless the borrower proves that repaying it would be an undue hardship.

The rule tightened in steps. In 1976 Congress barred discharge during the first five years of repayment, with an exception for hardship. In 1990 the period was extended to seven years. In 1998 the time limit was removed for federal loans, and in 2005 the restriction was extended to many private student loans. Courts have to define "undue hardship," and many follow a three-part test from Brunner v. New York State Higher Education Services Corp., a 1987 decision of the Second Circuit: the borrower cannot maintain a minimal standard of living if forced to repay, that situation is likely to continue for a significant part of the repayment period, and the borrower has made good-faith efforts to repay.

The best case for the system, stated fairly

Defenders of the loan system say something like this: "Student loans are unsecured. The lender cannot repossess a degree, so lenders need strong repayment tools. Without federal loans, many low- and middle-income students couldn't borrow at all, because private lenders wouldn't lend to an eighteen-year-old with no credit and no collateral. A degree increases earnings over a lifetime, so borrowing against it makes sense for most people. And the bankruptcy rule is there because otherwise borrowers could discharge the debt right after graduation and keep the degree."

That's an honest argument. Some of it is true. For most students, a degree has paid for itself, and the loans did make college possible for people who couldn't have gone otherwise.

The conservative critique, in three points

1. Nobody is underwriting the loan. A bank deciding whether to lend $100,000 for a house asks whether the house is worth it and whether the borrower can pay. The federal loan asks neither. Broadly the same limits apply whether the student is going into nursing or into a program with a record of poor outcomes. A loan that pays no attention to whether it can be repaid is a grant that hasn't admitted it yet.
2. The schools have no skin in the game. A college collects the tuition up front. If the student can't repay, the college suffers no loss. A college with an incentive to charge what the market will bear has an easy time when the market is backed by a federal checkbook. Whether federal aid raises tuition is a debated question; Does Federal Aid Raise Tuition? The Bennett Hypothesis Tested weighs the evidence.
3. The gatekeepers are not accountable to families. Federal aid flows only to schools approved by accrediting agencies, which the department recognises. Accreditation, the Gatekeeper Nobody Elected That Decides Who Gets Federal Money explains how that works.

On forgiveness, the proposal that follows from all of this, Loan Forgiveness, the Strongest Case for It and Why It Still Fails states the case for it and answers it.

The bottom line

• Know the loan before you sign. Subsidized or unsubsidized, the fixed rate, the origination fee and the lifetime limits are all on your promissory note and on the Federal Student Aid website.
• Pay the interest on unsubsidized loans while you're in school if you can. Even small payments keep interest from being capitalized and turning into interest on interest.
• Run the numbers before you borrow. A Worksheet for the True Cost of a College Degree Before You Sign Anything gives you a method, and College, Apprenticeship or Trade School, How to Compare Your Options lays out the alternatives.
• Remember that a payment below the monthly interest lets the balance grow. Ask your servicer, in writing, how your plan treats unpaid interest.
• Treat the debt as a family decision. The person who signs it is often eighteen. A parent or mentor who sits down with the worksheet and the promissory note before the signature is doing the job the system does not do.