U.S. Markets closed

Where Do Federal Student Loans Come From?

Ann Marie Yager

Have you ever wondered where the money comes from for student loans? Here are some facts to help you understand the basics, including where your monthly student loan payment goes and why you pay interest.

Federal Student Aid Programs

All federal student aid programs -- which include student loans, Pell Grants and work - study, for example -- are funded by federal tax dollars paid by U.S. citizens.

Each year, Congress appropriates money to fund these programs as part of the annual budget process. Once the budget is finalized -- passed by both the House of Representatives and Senate -- and signed into law by the president, Congress electronically transfers the money from the Department of the Treasury to the Department of Education.

Title IV Requirements

To receive aid from the Department of Education, students need to attend an institution that meets certain federal requirements under Title IV of the Higher Education Act.

These requirements are meant to ensure that the institution and its employees understand the federal requirements for borrowers who receive federal student loans as well as requirements for institutions, including but not limited to campus safety and protection of civil rights.

[Read: What to Know About Federal Student Loan Repayment Options.]

Your institution's financial aid administrators are responsible for distributing to you your loan funds and any Pell Grant money you qualified for to pay for your education and related costs.

Where the Money Goes When You Repay Student Loans

Once you have signed your promissory note, which is the document where you promise to pay back the funds you are borrowing, you can begin repaying your loan. The federal government owns 10 student loan servicers that manage the account status and repayment of your loans.

When you begin paying back your loans, you send the payments to your servicer. You should receive a monthly statement from your servicer either by postal mail or email.

If you have more than one federal student loan, you may have more than one servicer. A complete list of Department of Education student loan servicers is available online.

[Read: When to Contact Your Student Loan Servicer.]

When you make a payment, the money does not stop at the servicer. The servicer is simply collecting it for the federal government and managing your account status. The money is then sent to the Department of the Treasury, since that is where the student loan funding came from originally.

Each year the process starts over again, with Congress appropriating more money for the student aid programs as some federal student loan borrowers repay. The national federal student loan debt total of $1.51 trillion means that is the amount still owed the federal government by more than 40 million current and former students.

Why There Is Interest on Student Loans

Unless you are borrowing money from your parents or a very generous friend, you will be paying interest on those funds. Whether it's for your cellphone, car, college education or house, interest is the cost a company or individual charges you for borrowing.

[Read: How Student Loan Debt Is Different From Other Types of Debt.]

For federal student loans, the interest that accumulates on a loan balance is to cover the costs associated with servicing your loan.

In the private student loan space, lenders usually determine your interest rate based on your credit score. When your credit score is high, that demonstrates that you have a history of responsibly paying your bills, which means you are a lower risk and will likely be offered a lower interest rate for money you borrow.

On the other hand, if you have had some struggles with your bills -- maybe you have frequently paid bills late, had a debt sent to a collection agency or don't have a lot of credit history -- you are likely to have a lower credit score. In that case, lenders will likely offer you a higher interest rate to offset the higher risk of lending you money.

Understanding the cycle of federal funding can help you develop an appreciation for the complexity of the financial system that you are a part of as a student loan borrower.

More From US News & World Report