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Fixing the student loan interest rate problem, at no cost (essay)

A No-Cost Interest Rate Fix
June 7, 2012

A no-cost solution to the impasse on extending the 3.4 percent interest rate on some federal student loans is hiding in plain sight.

Lawmakers can cut interest rates and lower student debt burdens at no taxpayer cost starting with the upcoming school year by pegging interest rates to those on 10-year Treasury bonds, plus 3.0 percentage points. This policy is better for all students, even those who would qualify for the 3.4 percent interest rate. Yet, in a show of election-year theatrics, lawmakers are deadlocked over how to offset the $6 billion cost of extending the 3.4 percent rate -- raise taxes or repeal part of the 2010 health care law -- and aren’t looking for what helps students most.

Why is Congress debating interest rates on student loans in the first place?

Since 2006, the Department of Education has issued most federal student loans (Unsubsidized Stafford loans) with a fixed 6.8 percent interest rate. In recent years, however, Congress has allowed undergraduates with greater financial need to get lower rates on Subsidized Stafford loans. Funding has now dried up for those lower rates -- which hit 3.4 percent last school year -- so all newly issued loans starting this school year will carry the 6.8 percent rate. That is, unless Congress comes up with more funding. So it is now a “how do you pay for it?” debate that is going nowhere.

Congress and the president should just call a truce and agree instead to peg the rate on all newly-issued loans (for graduate and undergraduates) to 10-year Treasury bonds, plus 3.0 percentage points. The Congressional Budget Office says this plan (which was introduced as a Senate bill on Wednesday) reduces the cost of the loan program by $52 billion over 10 years because the agency estimates that rates on 10-year Treasury notes will eventually rise and newly issued loans will carry rates higher than 6.8 percent.

Students would be better off under this plan than what Congress is currently debating. That is true even though the formula doesn’t get the rate on Subsidized Stafford loans down to 3.4 percent (at today’s 10-year Treasury rate it would be 4.5 percent). While Congress and the president have been focused on the seemingly magical number of 3.4 percent for Subsidized Stafford loans, they’ve overlooked the fact that a smaller rate cut applied to both Subsidized and Unsubsidized Stafford loans adds up to a better deal for borrowers. Here’s why.

Undergraduate students (who are still dependents) can borrow up to $5,500 in Unsubsidized Stafford loans their first year in school, $6,500 in the second, and up to $7,500 each year thereafter. However, Subsidized Stafford loans, those that qualify for the 3.4 percent interest rate, max out $2,000 below those annual limits. So undergraduates who qualify for the lower rate, but borrow the maximum in total federal loans, actually have both types of loans.

Under the proposed extension of the 3.4 percent rate, one loan would charge 3.4 percent interest and the other 6.8 percent. Under the 10-year Treasury note proposal, rates on both loans would be the same, at 4.5 percent based on today’s rates.

While the weighted average interest rates a student will pay under either plan are very close, the 10-year Treasury plan is more favorable because Unsubsidized Stafford loans accrue interest annually while a borrower is in school. (No interest accrues on Subsidized Stafford loans during that time.) As a result, lowering that rate on both loan types to 4.5 percent, as the 10-year Treasury note plan would do, means borrowers would leave school with lower overall loan balances than they would under current law or the pending proposals to extend the 3.4 percent interest rate on some loans.

For example, a first year student’s loan balance upon graduating four years later would be $6,044 under the proposed extension of the 3.4 percent rate. But under the 10-year Treasury note plan, it would drop to $5,860 because the Unsubsidized Stafford portion of the loan balance accrues interest at the lower rate of 4.5 percent while the student is in school. Therefore, the student’s monthly payment would be $3 lower under the 10-year note plan than if he were to take out a Subsidized Stafford loan at 3.4 percent.

Graduate students and undergraduate borrowers who don’t qualify for any of the loans at 3.4 percent also would realize savings under the 10-year Treasury note plan because they would pay lower rates, too.  Parent and Graduate PLUS loans rates would be lower as well.

So far Congress and student advocates haven’t warmed to this alternative, despite its clear benefits. Some would-be supporters are concerned that pegging fixed rates to the 10-year Treasury note would mean that rates on new loans could eventually be higher than 4.5 percent or even 6.8 percent. There is certainly a risk of that happening, but that’s the only way to reduce the cost of the loan program in the long run while lowering interest rates in the short run.

Besides, there is merit to pegging rates to a market index. Students will get lower rates when the economy is weak and will pay higher rates only if the economy improves. That’s a fair approach, for both taxpayers and students.

If only Congress would look past the politically charged 3.4 percent interest rate, they would see that a better plan for reducing student debt is right in front of them.

Bio

Jason Delisle is director of the Federal Education Budget Project at the New America Foundation.

 

 

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