What is a federal Direct Loan and How does it work?

Direct loans are federal student loans given by the United States Department of Education. These loans are an excellent starting point for most borrowers, as they offer low interest rates and generous protection for the borrower. Federal Direct Loans are available to both undergraduate and graduate borrowers and can be used to cover a variety of educational expenses. Direct loans are classified into four types, each with its own set of qualifying rules and interest rates.

How does a Federal Direct Loan work?

To see if you qualify for direct loans, submit the Free Application for Federal Student Aid (FAFSA), which opens October 1 each year. Once your school has reviewed your FAFSA, it determines the type of aid you qualify for based on your expected family contribution, financial need and other factors. If you qualify for Federal Direct Loans, you will see an offer in your award letter.

You can take some or all of the direct loan assistance offered. You must fill out an acceptance advisory, which reminds you of your obligation to take Federal Direct Loans. Borrowers are also required to sign a principal promissory note, which is a document that describes the details of your loan, including important payment information.

At this time, the Ministry of Education will distribute the funds directly to your school. The school will set aside money for tuition, fees, and other expenses that you owe. If there is any loan money left, the school will distribute it to you or your parents if they took out Parent Plus loans.

Types of direct loans

There are four types of direct loans, each with different loan limits and interest rates. Which one you get depends on your financial need and education level.

Direct subsidized loan

A directly subsidized loan is only available to undergraduate students who have demonstrated financial need. It offers the greatest benefit to student loan borrowers because the federal government subsidizes the interest over a certain period. This means that the Ministry of Education pays to collect interest under the following circumstances:

• When the student attends school at least half the time.

• During the first six months following the student's graduation or departure from school.

• When the loan is overdue.

By default, Direct Subsidized Loans are placed on the Standard Repayment Plan. This plan divides your federal student loans into fixed, equal payments over a 10-year period. But you can change your payment plan at any time for free.

The interest rate on direct subsidized loans is now 5.50 percent, plus a minor loan charge of 1.057 percent will be taken from your loan amount before the funds are issued.

Direct Unsubsidized loan

Undergraduate and graduate students and qualified professionals have direct access to unsubsidized loans. Unsubsidized direct loans are similar to direct subsidized loans, but they do not support interest.

Instead, interest accrues immediately, and students are responsible for any interest as the money is disbursed. However, when a student is enrolled in school at least half the time, or is in deferment or forbearance, he may choose not to pay the interest. This will take advantage of the accumulated interest - in other words, add it to the total loan balance.

Unsubsidized direct loans have interest rates of 5.50% for undergraduate students and 7.05% for graduate and professional borrowers. An origination fee of 1.057 percent is applied before the loan is disbursed.

Direct Plus Loan

The Direct PLUS loan is available to eligible graduates, professional students, or eligible parents of a college student. Depending on the borrower, this is usually called either a "Grad Plus Loan" or an "Additional Principal Loan".

Direct PLUS loans are not based on need. It requires a credit check, and must meet the Department of Education's borrower requirements to be approved. However, applicants who do not have strong credit may still be granted funding if they can provide endorsement of the loan. A guarantor is like a co-signer because it guarantees that it will pay the debt if you cannot. You may also get a PLUS loan if you have evidence of a situation that led to your negative credit.

The interest on Grade Plus and Parent Plus loans is 8.05%, and its principal amount is equal to 4.228% of the total loan amount.

Direct Consolidation Loans

Borrowers who have taken out multiple federal student loans can simplify their repayment experience with a Direct Consolidation Loan. This type of loan combines all of your outstanding federal debt into one loan, with one monthly payment and a fixed interest rate. To consolidate your debts, you will need to make payments up front.

Applying for a direct consolidation loan is free of charge, and you can extend the loan period up to 30 years. This lowers your monthly payment, but it also means that it will take longer to pay off your loans, which means you'll pay more interest over the life of the loan.

There are other downsides to direct consolidation loans. Your fixed interest rate is determined on the basis of a weighted average of all loans, so you won't necessarily save on interest costs using this method. Consolidation also adds the remaining interest on your original debt to the new principal balance.

Finally, if you're working toward public service debt forgiveness, taking out a direct consolidation loan will nullify any progress you've made toward the needed 120 payments. This implies you'll have to restart the procedure.

How to get a federal direct loan

Direct loans are the best option for many student borrowers. To get started, follow these steps:

Complete the FAFSA. The FAFSA uses tax returns, pay stubs and other government documents to determine your expected family contribution and financial aid that you qualify for.

Meet the admission requirements. Since obtaining a loan requires in-house counseling, you must liquidate it before receiving the loan.

Take only what you need. Just because you can be approved for the full loan amount doesn't mean you have to take it. Borrow only what you need for school, because eventually you will have to pay it back with interest.

Sign your master bill. Your principal promissory note is basically your contract with the lender. It outlines your obligations to pay off the debt and the consequences if you fail to do so. You can't get your loan without signing it.

Your school receives funding. Once you complete the paperwork, the Ministry of Education will disburse the money directly to your school. If anything is left, it will go to you (or your parents, if they got the loan).

How Much Money Can Students Borrow in Federal Direct Loans?

Borrowing limitations on federal direct loans vary based on the kind of direct loan and the student's status.

Dependent undergraduates can borrow up to a total of $31,000 in direct loans, of which $23,000 may be subsidized.

An independent undergraduate student may be eligible for up to $57,500 in direct loans and up to $23,000 in subsidies.

Graduate students or independent professionals can borrow up to $138,500 in unsubsidized direct loans and up to the total cost of enrollment in Grade Plus loans. No more than $65,500 in subsidies can be awarded.

Federal Direct Loans vs. Private Student Loans

Both federal direct loans as well as private student loans have the same purpose: to bridge the financial gap left when other types of aid are no longer sufficient to meet educational expenditures. However, they differ in three important respects.

Requirements

While anyone in good academic standing who is enrolled at least half of the time at an accredited institution can get approved for direct federal loans, the same is true for private student loans. That cannot be said. Lenders approve private student loans based on other factors, such as credit score and income. This is why students often need a co-signer for loan approval.

Interest rate

Federal Direct loans have fixed interest rates, which means they will remain constant for the duration of the loan. On the other hand, private student loans can have fixed or variable interest rates. Although variable interest rates usually start low to make them more attractive to borrowers, they can fluctuate according to market conditions, so you may end up paying more overall.

Additionally, interest rates on private student loans are based on credit, so if you or your co-signer has a low score, you could end up paying 13 percent or more in interest.

Payment options

When you get a federal student loan, you don't have to make any payments for six months after you graduate. Additionally, if you are having trouble making payments, you can apply for an income-based payment plan to make your bill more affordable.

If you work for a qualifying nonprofit or government agency, you may be eligible for Public Service Loan Forgiveness to cancel your outstanding balance after making 120 consecutive payments.

However, this protection is not available through private lenders. While some may offer a grace period of six months or more after graduation, they are not required to do so.

If you are unable to pay, the only options usually available are deferment or forbearance, in which case the interest will continue to accrue and eventually become part of the principal. This lack of versatility should be considered while considering your alternatives.

Bottom Line

Borrowers of student loans should look into all options for funding their college education, including applying for scholarships and grants. And as costs continue to rise, loans can help students pursue higher education. For qualified borrowers, Federal Direct Loans offer competitively low interest rates and protections including deferment, forbearance, loan forgiveness options, and income-based repayment plans.