Change the Interest Rate Structure for Student Loans

The federal government operates several loan programs to help students and their parents pay for postsecondary education. The terms and eligibility for loans made under those programs vary widely. Subsidized loans feature interest forgiveness while students are enrolled and for six months after they leave school, but those loans are available only to those with demonstrated financial need. Unsubsidized loans, without interest forgiveness, are available to any student regardless of need. PLUS loans are available to parents of dependent students and to graduate and professional students; their terms are similar to those of unsubsidized loans, except that interest rates are higher. Regardless of the type of loan, borrowers benefit from few or no requirements with respect to credit history or collateral and from repayment options that take into account the borrowers' financial circumstances.

Currently, the interest rate on all new unsubsidized and subsidized loans to nonundergraduate students is 6.8 percent. On all new PLUS loans, the interest rate is 7.9 percent. For the 2011-2012 academic year, the interest rate on new subsidized loans to undergraduate students will be 3.4 percent, but for all subsequent years, that rate will be 6.8 percent because of the expiration of a provision in the College Cost Reduction and Access Act of 2007.

This option would change the structure of interest rates on federal student and parent loans to resemble those on fixed-rate mortgage loans. In particular, the interest rate on new loans would depend on conditions in financial markets at the time of origination but remain fixed for the life of the loan. Under this option, the interest rate on all new federal student and parent loans would be set to the interest rate on 10-year Treasury notes at the beginning of the academic year in which the loan is originated plus 3 percentage points. This option would reduce federal outlays by $900 million from 2012 to 2016 and by $52 billion from 2012 to 2021, the Congressional Budget Office estimates. (The Federal Credit Reform Act of 1990 requires that the federal budget record all costs and collections associated with a new loan in the year in which the loan is disbursed.)

The large jump in savings between the first and second halves of the 10-year estimating window reflects CBO's projections of a steady increase in Treasury interest rates over the first few years of the 2012-2021 period. Initially, interest rates on certain student loans under this option would be lower than under current policies, generating some costs for the government. As interest rates rise, however, the rates on student loans under this option would grow to be higher than under current policies, generating large savings.

A rationale for this option is that it would focus the loan programs' role on providing access to financing for all students at an interest rate not generally available to borrowers who have neither a demonstrated credit history nor collateral. (The Federal Pell Grant Program would continue to provide tuition relief to students with the greatest financial need.) In addition, the interest rate on student and parent loans would adjust to conditions in financial markets at the time a loan was originated, making the government subsidy equally valuable in relatively high and relatively low interest rate environments. However, borrowers would continue to benefit from predictable monthly payments because of the fixed interest rate over the life of a loan.

An argument against this option is that, given CBO's projections of the interest rates on 10-year Treasury notes from 2012 to 2021, the option would raise the expected average interest rate on student and parent loans. Consequently, for most loans, the interest accrued and monthly payments when borrowers left school would be greater than under current policies. The anticipation of higher debt payments might limit the fields of study students would consider and the types of jobs they would seek. Also, borrowers who were in school during times of tight financial markets would pay higher interest rates than borrowers who were in school during other times.