A Solution to the Student Loan Showdown?

May 8, 2012 | Other Spending

Impasses and showdowns have become the norm over the past few years, and it is turning out to be no different with student loans. For background, in 2007, Congress passed a law that gradually reduced subsidized Stafford student loan rates to their current 3.4 percent interest rate. Since the provision was only temporary, that rate will rise to 6.8 percent on July 1. Both chambers have been working on bills to extend the 3.4 percent rate, and the difference--of course--is one of offsets. The House bill, which passed the chamber a few weeks ago, offsets the extension by eliminating the Prevention and Public Health Fund from the Affordable Care Act. The Senate bill, which fell short of the requisite 60 votes with a 52-45 vote, offsets the extension by closing a loophole that allows S corporation owners to avoid the Medicare payroll tax on their income.

However, our colleague Jason Delisle at the New America Foundation's Federal Education Budget Project points out a way to temporarily lower rates while also reducing the deficit, from CBO's Budget Options (Mandatory Spending Option 11): linking student loan rates to long-term Treasury rates.

The CBO has provided a cost estimate for a proposal that would link the interest rate on all newly-issued federal student loans—Subsidized and Unsubsidized Stafford, Graduate and Parent PLUS—to long-term U.S. Treasury borrowing rates.  (The CBO isn’t endorsing the proposal, just showing lawmakers how it would ‘score’.) Interest rates would still be fixed for the life of the loan, but the rate would change each year based on market rates for Treasury notes. The proposal sets the rate for newly issued loans based on the interest rate on 10-year Treasury notes at the time the loan is issued, and adds a premium of 3 percentage points to it.

That formula would make the rate on loans issued this fall fixed at 4.9 percent, 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 for only some undergraduates. Of course, next year the rate could be higher or lower depending on what happens to interest rates in the market. The CBO assumes it will be higher. That’s where the deficit reduction (i.e. cost savings) come in.

If and when the interest rates on 10-year U.S. Treasury notes rise, the fixed interest rate on newly-issued student loans will also increase. Once rates on those securities rise above 3.8 percent – the rates are currently 1.9 percent – the interest rate on newly issued student loans will exceed 6.8 percent, the current fixed interest rate. Because CBO assumed that interest rates will rise in the future, it assumed that borrowers will pay higher rates in the future than under current law, reducing spending and the deficit. According to the estimate, this new rate structure would reduce the deficit by $52 billion over ten years.

Delisle notes that Treasury rates are lower than when CBO originally estimated the policy in March 2011, so the savings would likely be lower. Still, the idea remains the same. As borrowing rates stay low, so will the Stafford rates relative to where they are scheduled to be; when they rise, so will the loan rates. Also, this system would provide more certainty than either the temporary system that both bills would keep in place or a variable rate structure for student loans, where rates would be reset each year. Delisle's proposal certainly is an interesting idea worth considering to break the impasse over student loan rates.