Federal Direct Loans: Subsidized vs. Unsubsidized

The rising cost of a college degree has more students than ever borrowing to cover their expenses. While some students opt for loans from private lenders, an estimated 44 million borrowers have taken out loans from the U.S. Department of Education. Of those, 32.1 million borrowers owe Federal Direct Loans.

These loans offer numerous benefits, including flexible repayment options, low interest rates, the option to consolidate loans and forbearance and deferment programs. Federal Direct Loans may be subsidized or unsubsidized; before you borrow, it’s important to understand how the two loan types compare. (See College Loans: Private vs. Federal.)

There are a few requirements you must meet to be eligible for a Federal Direct Loan. For both subsidized and unsubsidized loans, borrowers must:

• Be enrolled at least half-time at a school that participates in the Federal Direct Loan program.
• Be a U.S. citizen or eligible noncitizen.
• Have a valid Social Security number.
• Maintain satisfactory academic progress.
• Have completed a high school diploma or its equivalency.
• Not be in default on any existing federal loans.
• Be registered with the Selective Service (for males ages 18 to 25).

The two biggest differences between subsidized and unsubsidized Direct Loans have to do with financial need and enrollment status. Direct Subsidized Loans are only available to undergraduates who have a demonstrated financial need. Both undergraduates and graduate students can apply for a Direct Unsubsidized Loan and there’s no financial need requirement.

To apply for either type of loan, you’ll need to fill out the Free Application for Federal Student Aid (FAFSA). This form includes information about your income and assets, and those of your parents. Your school uses your FAFSA to determine which types of loans you qualify for, and how much you’re eligible to borrow. (See An Introduction to Student Loans and the FAFSA.)

The Federal Direct Loan program has maximum limits for how much you can borrow annually through a subsidized or unsubsidized loan. There’s also an aggregate borrowing limit.

For 2018, first-year undergraduate students can borrow a combined $5,500 in subsidized and unsubsidized loans if they’re still financially dependent on their parents. Of that amount, only $3,500 may be subsidized loans. Independent students – and dependent students whose parents don’t qualify for Direct PLUS loans – can borrow up to $9,500 for their first year of undergraduate study. Again, subsidized loans are limited to $3,500 of that amount.

The borrowing limit increases for each subsequent year of enrollment. The total aggregate subsidized loan limit is $23,000 for dependent students, with another $8,000 allowed in unsubsidized loans. For independent students, the aggregate limit is raised to $57,500, with the same $23,000 cap on subsidized loans. Graduate or professional students can borrow up to $138,500 in Direct Loans, with $65,500 of that being subsidized. (See Your Kid's College Loan: Who Should Foot the Bill?)

If you’re a first-time borrower after July 1, 2013, there’s a limit on the number of academic years that you can receive Direct Subsidized Loans. The maximum eligibility period is 150% of the published length of your program. In other words, if you’re enrolling in a four-year degree program, the longest you could receive Direct Subsidized Loans is six years. No such limit applies to Direct Unsubsidized Loans.

Federal loans are known for having some of the lowest interest rates, especially compared to certain private lenders that may charge borrowers a double-digit APR. Both Direct Subsidized and Unsubsidized Loans currently carry a 4.45% APR for undergraduate students. The APR increases to 6% for graduate and professional students. And unlike some private student loans, those rates are fixed, meaning they don’t change over the life of the loan.

One thing to note about the interest: the federal government pays the interest owed on Direct Subsidized Loans for the first six months after you leave school and during deferment periods. You’re responsible for the interest if you defer an unsubsidized loan, or if you put either type of loan into forbearance.

In terms of repayment, you have several options. Unless you ask your lender for a different option, you’ll automatically be enrolled in the Standard Repayment Plan. This plan sets your repayment term at up to 10 years, with payments divided equally each month. The Graduated Repayment Plan, by comparison, starts your payments off lower, then raises them incrementally. This plan also has a term of up to 10 years, but because of the way payments are structured, you’ll pay more than you would with the Standard option.

There are also several income-driven repayment plans for students who need some flexibility in how much they pay each month. Income-based repayment (IBR), for instance, sets your payments at 10% to 15% of your monthly discretionary income and allows you to stretch repayment out for 20 or 25 years. The advantage of income-driven plans is that they can lower your monthly payment – but there’s a catch. The longer it takes you to pay off the loans, the more you’re paying in interest. And if your plan allows for some of your loan balance to be forgiven, you may have to report that as taxable income. (See Do You Really Have Student Loan Forgiveness?)

The upside is that paid student loan interest is tax-deductible. For 2018, you can deduct up to $2,500 in interest paid on a qualified student loan and you don't have to itemize to get this deduction. Deductions reduce your taxable income for the year, which may lower your tax bill or add to the size of your refund. If you paid $600 or more in student loan interest for the year, you’ll receive a Form 1098-E from your loan servicer to use for tax filing.

Both Direct Subsidized and Unsubsidized Loans can be useful in paying for college, but one may be more appropriate than the other, based on your financial needs. Just remember that either type of loan eventually must be repaid with interest, so think carefully about how much you’ll need to borrow and which repayment option is going to work best for your budget.