Solving the Interest Rate Quandary: Two Feasible Proposals

May 22, 2012 |
There are a number of ways Congress could set interest rates on student loans that address the flaws in the current system. But there is no free lunch. Every option will force policymakers to make trade-offs. Below are two proposals that would address the shortcomings in the current system while minimizing the tradeoffs and costs involved.
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The interest rate on federal student loans has never garnered this much public attention. The president has been talking up his proposed one-year extension of the 3.4 percent interest rate on newly-issued Subsidized Stafford loans since his 2012 State of the Union address, and with bills to extend the 3.4 percent rate pending in Congress, every major newspaper has covered the issue. Regardless of whether Congress adopts a one-year extension of the lower interest rate, policymakers still need to rethink how interest rates on federal student loans are set. The current rates are arbitrary, inflexible, and inequitable.

But before discussing those shortcomings and ways to address them, reformers must understand what federal student loans are not. They are not profitable for the government, nor are they a bad deal for borrowers, even at the pending 6.8 percent interest rate.

According to the Congressional Budget Office (CBO), of all the government’s loan programs the federal student loan program is the most subsidized and the most expensive. In most years, taxpayers will spend more subsidizing student loans ($12 billion) than they will subsidizing all of the home mortgages backed by Fannie Mae and Freddie Mac ($5 billion) and the Federal Housing Administration ($3.5 billion) combined, which effectively encompasses all newly-issued mortgages. As a result of these subsidies, the interest rates on federal student loans are far better than the interest rates private banks would offer to similar borrowers.

Much of the impetus for reforming student loan interest rates is driven by the belief that the government is charging interest rates that are unfairly high and thereby profiting off of borrowers. That misunderstanding abounds mainly because federal law prohibits government agencies from using calculations that demonstrate the true cost in official estimates and requires that they instead use a method that the nonpartisan CBO says “[does] not provide a full accounting of what federal credit programs actually cost the government.”

Since the CBO (along with financial economists) has rebuffed the claim that the government “profits” from student loans, proposals to lower interest rates based on the profitability argument are unlikely to resonate with policymakers, and therefore should not factor into the debate on reforming the interest rate. Instead, discussions should focus on the arbitrary, inflexible, and inequitable rates in place now.

Congress set the current fixed rates (6.8 percent for Stafford loans and 7.9 percent for PLUS loans) in law in 2002 based on projections of what the average variable interest rates would be in the future. Congress also literally wrote those exact figures into federal law—they aren’t pegged to a market benchmark—so the rates apply to loans issued every year no matter where the market and economic forces push interest rates.

Similarly, the loans are inequitable in that they provide very different levels of subsidies to borrowers depending on when they borrow. The subsidy on loans issued at the 6.8 percent interest rate in 2007 when the economy was booming and interest rates were relatively high was much larger than the subsidy provided to students who take out loans at 6.8 percent in today’s low-interest rate, slow-growth economy.  Put another way, the subsidy a borrower receives on a loan is a function of how low the interest rate they pay is compared to what a private lender would charge to make the exact same loan. If market interest rates are high and the federal government charges 6.8 percent, the borrower receives a larger subsidy than when market interest rates drop and the government continues to issue loans at 6.8 percent.

According  to the CBO and an analysis published by the National Bureau of Economic Research, the average subsidy that the government provided on a typical loan made in the 2006-07 academic year through the direct loan program was worth almost twice as much ($20 for every $100 borrowed) as the subsidy borrowers receive on the same loans made today ($11 for every $100 borrowed).

There are a number of ways Congress could set interest rates on student loans that address the flaws in the current system. But there is no free lunch. Every option will force policymakers to make trade-offs. Below are two proposals that would address the shortcomings in the current system while minimizing the tradeoffs and costs involved.

    Market-Based Fixed Rate

    Under this proposal, Congress would peg fixed interest rates on all newly-issued federal student loans—Subsidized and Unsubsidized Stafford, Graduate and Parent PLUS—to long-term U.S. Treasury borrowing rates, plus a markup set high enough to partially offset the costs associated with defaults, collections, delinquencies, deferments, forgiveness, etc., but low enough to still provide borrowers with a subsidy compared to market rates. Interest rates would still be fixed for the life of the loan, but the rate would change each year loans are offered based on market rates for 10-year Treasury notes, plus a markup of 3.0 percentage points.

    That formula would make the rate 4.9 percent for loans issued this fall, a big drop from the current 6.8 percent rates. What’s more, that rate would be available to all undergraduate and graduate borrowers, unlike the proposal pending in Congress to provide lower rates only to some undergraduates. Of course, next year the rate could be higher or lower depending on what happens to interest rates in the market. In a cost estimate for this proposal, the CBO assumes rates will eventually be higher than 6.8 percent for loans issued in the future. This would allow for deficit reduction (i.e., cost savings) as those higher rates would lower costs for the government. The agency estimates the proposal would reduce costs compared to the current 6.8 percent rate by $52 billion over 10 years.

    Of course, this proposal has a tradeoff—if the economy improves and long-term interest rates rise, rates on newly-issued student loans would rise with them. With interest rates based on existing market conditions, borrowers should theoretically get the same subsidy regardless of when they borrow. That is, the proposal would not provide students that borrow when interest rates are high with a larger subsidy than students who borrow in a year when interest rates are low. The subsidy would be consistent every year for every borrower.
    Variable Rate with Option to Lock in a Fixed Rate

    This proposal would set a variable rate for all newly-issued federal education loans that adjusts annually based on short-term U.S. Treasury securities, plus a markup to partially offset costs. However, it would not set a cap on how high rates could rise. Instead, borrowers would be given a one-time option to lock in a fixed rate at a premium above the current variable rate. Congress should set a premium that reflects the cost that fixed rate loans impose on taxpayers in the form of interest rate risk. For example, lawmakers could set the premium at the difference between the interest rates on 1-year and 20-year Treasury securities today, which is one measure of what lenders charge to provide fixed rates for long periods of time. That premium would be about 2.5 percentage points. Under this scenario, if the variable rate is 4 percent, borrowers could lock in a fixed rate at 6.5 percent. The fixed-rate lets borrowers choose certainty in their financial obligations, but it does not come at the high cost to taxpayers that a cap on variable rates would entail.

    This is similar to the policy in place in the 1990s and early 2000s, except during that time borrowers could lock in the current variable rate as a fixed rate (without a premium charge) only through the consolidation program. That provision proved extremely costly and provided many borrowers with huge windfall subsidies as they secured 20- and 30-year loans at rates below 3 percent after they left school. It had the opposite effect for borrowers who used consolidation as their only option to extend repayment in the late 1990s and were forced to lock in rates above 8 percent. In response, this proposal would not make electing a fixed rate a mandatory part of consolidation, though the option would be available on all loan types.

    This option presents the potential for significant budgetary costs compared to current policy. However, those costs would be mitigated because it is likely that most borrowers would choose to lock in a fixed rate. Indeed, if borrowers lock in fixed rates similar to those offered under current law, the additional costs of the policy would be minimal because the government would not have to incur the costs associated with lower interest rates. Even so, borrowers would be better off than they are under the current policy because they would be able to choose between fixed and variable rates.

    But more choices pose their own set of problems. As the government provides more choices and options for borrowers, it’s more likely that borrowers will be confused or make poorly-informed decisions. Some borrowers would inevitably believe that the government gave them a raw deal if they chose to lock in a fixed interest rate at the peak of an interest rate cycle only to watch rates fall in later years.

    While some might argue that this proposal should include an option for borrowers to refinance at lower fixed rates (when the market allows for such rates) even after locking in the fixed rate, similar to a home mortgage, this would be an extremely costly provision. It would put the government in a no-win situation with respect to interest rate risk that taxpayers must finance. Though borrowers could pay a fee to refinance the loan at a lower rate, mitigating the cost to the government of providing the option, the fee would likely have to be so high that the option would provide no real benefit to borrowers.

Many readers may wonder why I have not proposed a third option that caps variable rates at the existing 6.8 percent fixed rate. As many know, such an approach would represent a return to the policy of the 1990s and early 2000s whereby newly-issued federal loans carried variable rates that adjusted annually based on short-term U.S. Treasury securities, plus a markup to partially offset costs. While that policy included a cap on the variable a rate of 8.25 percent, some today favor an even lower cap of 6.8 percent, the current fixed rate.

This proposal is excluded from the list above because it would cost approximately $200 billion over the next 10 years, according to preliminary estimates that the CBO has provided to congressional staff. The proposal is costly because it allows borrowers to enjoy low variable rates when market rates are low while guaranteeing that borrowers will never pay more than the current 6.8 percent fixed rate when interest rates increase. In other words, it shelters borrowers from the financial tradeoffs that they would normally face when they choose between fixed and variable interest rates on loans in the private market. Variable rates may be low at first, but can easily increase under the right market conditions. Fixed rates might be higher on average, but they provide certainty. The variable-rate-with-a-cap proposal does not, however, make that fundamental tradeoff disappear. It just shifts the cost entirely onto taxpayers.

 To put the $200 billion price tag in perspective, Congress is currently having trouble funding a one-year extension of the 3.4 percent student loan interest rate, which would only cost $6 billion over 10 years. Even more compelling, Congress could fund an $8,000 maximum Pell Grant (up from $5,550 today) for the next 10 years if it allocated an additional $200 billion to the program over that time period.

Even though a variable rate policy that caps rates at 6.8 percent is far too costly to be politically viable in Congress, the other two proposals illustrate that policymakers can make meaningful improvements on interest rates for minimal cost, or no cost at all. Students and aid advocates alike would be wise to take advantage of the fact that interest rate reform is fresh in the minds of lawmakers and rally around some version of a more economically feasible proposal.