Earning a college education is one of the best investments for your future, but it can become a nightmare if you do not take the careful measures into fully understanding how student financial aid actually works.
When filing your Free Application for Federal Student Aid, also known as the FAFSA, do you know exactly what you're getting into?
What is the FAFSA?
FAFSA is the largest provider of financial aid in the United States. A part of the U.S. Department of Education (ED), the office of Federal Student Aid provides more than $150 billion in federal grants, work study funds and loans each year to more than 13 million students. FAFSA is the form used by the ED to determine your Expected Family Contribution (EFC) by conducting a "need analysis" based on financial information the student provides, including income, assets, household information and more. After the student submits the form, it gets processed by a federal processor contracted by the ED. The results are electronically transmitted to the financial aid offices of the schools listed on the student's application.
Federal student aid covers such expenses as tuition and fees, room and board, books and supplies and transportation. Aid also can help pay for other related expenses, such as a computer and dependent care.
What are the types of federal aid?
The three types of federal student aid include grants, work study and loans. Grants are financial aid that doesn't need to be repaid. Federal Work Study provides part-time jobs for undergraduate and graduate students with financial need, allowing them to earn money to help pay education expenses. A student loan is borrowed money used to pay off education-related expenses and must be repaid with interest.
Making it work
One of the reasons student-loan debt is soaring is because many student's fail to understand what they're signing up for. When accepting any loan, you will be signing into a binding agreement to repay the amount borrowed, plus any applicable interest that may accrue. Most student loans allow you to defer repayment until after you graduate. But just like any other loans, defaulting can negatively affect your credit and cause other serious financial consequences. Therefore, it is important to carefully read and understand the terms and conditions of each student loan you're considering, as well as to borrow only what you need and can afford to repay.
Understanding federal student loans
The U.S. Department of Education offers two federal student loan programs:
1.The William D. Ford Federal Direct Loan (Direct Loan) Program.
2.The Federal Perkins Loan Program.
The William D. Ford Federal Direct Loan Program, also known as the Federal Stafford loan, is the largest and most popular federal student loan program. Under this program, the ED is your lender. There are four types of direct loans available:
- Direct Subsidized Loans are loans made to eligible undergraduate students who demonstrate financial need to help cover the costs of higher education at a college or career school.
- Direct Unsubsidized Loans are loans made to eligible undergraduate, graduate and professional students, but in this case the student is not required to demonstrate financial need to be eligible for the loan.
- Direct PLUS Loans are loans made to graduate or professional students and parents of dependent undergraduate students to help pay for education expenses not covered by other financial aid.
- Direct Consolidation Loans allow you to combine all of your eligible federal student loans into a single loan with a single loan servicer.
To find out the annual award limits for each of these loans, click here.
Read MoreHow not to drown in student-loan debt
The Federal Perkins Loan Program, often called Perkins Loans, is a school-based loan program that offers low-interest loans to help undergraduate and graduate students with exceptional financial need. It is a subsidized loan made by colleges and universities, which means the school is your lender. The loan is made with government funds, and your school contributes a share.
What's the difference between subsidized and unsubsidized loans?
A subsidized loan is a need-based loan, which means it is awarded only to those students who show financial need on the FAFSA, whereas an unsubsidized loan is not based on financial need and can be available to anyone. The main difference between subsidized loans and unsubsidized loans is that the federal government pays the interest on subsidized loans while the student is enrolled in school at least half-time (For undergraduate students, half-time enrollment is at least 6 credits per term; for graduate students, half-time enrollment is at least 5 graduate credits per term). In an unsubsidized loan, interest begins accumulating as soon as funds are disbursed until the loan is paid in full.
—By Briana Supardi, special to CNBC.com