Concern Over Lender Subsidies or Borrower Benefits, Which Is It?

Jason Delisle - 

Last year when Congress cut subsidies to lenders making federally backed student loans, critics argued that the cut would hurt borrowers. They argued that lenders would reduce voluntarily provided "borrower benefits," because the subsidy cuts would make providing them unaffordable. The argument continues to appear in the press, and certain Members of Congress lamented borrower benefits again during consideration of the Higher Education Act reauthorization earlier this month.

At first glance, the concern over borrower benefits seems legitimate. Congress' decision to cut taxpayer supplied subsidies to student loan providers led some lenders to cut voluntarily provided borrower benefits. But upon closer examination, the concern, especially as expressed by lawmakers, appears dubious. Borrower benefit supporters in Congress are either confused about the workings of the federal student loan program or they are shaking down taxpayers to over-subsidize banks.

Simply consider the fact Congress can provide any level of borrower benefits it chooses while subsidizing lenders at their current rate. This is possible because student benefits and lender subsidies are set separately under the existing federal student loan program structure. Congress does not need to increase taxpayer subsidies to lenders to increase student benefits, and it can take action to ensure any borrower benefits are provided when lender subsidies are cut.

Lender Subsidies and Borrower Benefits are Separate

Lenders making federal student loans are entitled to two main subsidies. They receive a guaranteed interest rate on a federal loan issued and a guarantee against all but a small fraction of loses in cases of default. Specifically, the interest rate subsidy is structured so that a lender holding a federal student loan receives each financial quarter an interest rate equal to a short term market interest rate (91 day commercial paper) plus 2.3 percentage points (1.8 percentage points on loans made after July , 2008). Lenders can receive no more and no less.

Borrowers, on the other hand, pay a fixed interest rate of 6.8 percent for the life of the loan. The borrower makes loan payments to the lender, but if the payments are not enough to cover the lender’s guaranteed interest rate each financial quarter, the federal government pays the lender to fill in the gap. Conversely, if the borrower’s payments are more than enough to cover the guaranteed rate of return to the lender, then the lender remits the excess portion of borrower payments to the federal government.

Aside from the 6.8 percent fixed interest rate, borrowers are also guaranteed other benefits under federal law, such as income based repayment plans and generous deferment terms. No lender can deny the standard loan benefits to any student borrower.

But lenders typically have provided voluntary benefits beyond those required under law, such as lower interest rates for on-time repayment or reduced origination fees. Lenders have done so to win business from schools and students, and because the federal subsidy structure to the lenders as described above has proved more than sufficient to cover lenders’ costs for providing the standard borrower terms.

So You Want Borrower Benefits? Then Make Them Mandatory.

Critics of the lender subsidy cuts included in the College Cost Reduction and Access Act of 2007 – the cut in the quarterly interest rate guarantee from 2.3 to 1.8 percentage points over commercial paper rates – argue that the new subsidy rate will not be sufficient to induce lenders to provide benefits beyond those guaranteed to borrowers under law. Implicit in the argument is that Congress needs to subsidize lenders at higher levels to encourage them to pass along some of that subsidy to borrowers.

But if borrower benefit reductions are of such concern to Members of Congress, why not just provide them directly to the borrower using the money that would have gone to support a higher lender subsidy? Cut out the middleman. Congress could write in statute any of the benefits typically provided voluntarily by lenders, just as it does for all other loan terms. These might include an interest rate reduction for borrowers who make on-time repayments or the waiver of origination fees collected by the Department of Education. Lenders, of course, would be held harmless because of the structure of the loan program. They receive the same taxpayer subsidized, guaranteed rate of return regardless of the borrower benefits, no more and no less. The guarantee against default would be unchanged as well.

Yes, a new benefit costs taxpayers more. In the case of an interest rate reduction for on-time repayment, the government would have to spend more to fill in the gap between the lender’s guaranteed rate of return and the lower borrower interest rate. But the key point is that the lender would still receive the same guaranteed interest rate of return on a loan regardless of the government set borrower interest rate.

Members of Congress who claim to be borrower benefit supporters should not be troubled by the higher federal costs of providing benefits to borrowers directly instead of through middlemen lenders. After all, these same Members of Congress support higher taxpayer subsidies to lenders in the name of borrower benefits, which also translate to higher costs for taxpayers.

So why has no Member of Congress who is a proclaimed supporter of borrower benefits offered to provide them as a standard for all federal student loans?

Perhaps they misunderstand how the student loan program is structured. Or, perhaps they are really in favor of bigger bank subsidies, not better borrower benefits.