On July 1, 2013, interest rates on federal subsidized Stafford student loans, which are provided to low- and middle-income students, are scheduled to double from 3.4 percent to 6.8 percent. Congress acted to prevent an identical rate hike from going into effect on July 1, 2012, and is preparing to act to keep rates low again this year. There are key differences, however, between the various proposals to do so and unfortunately some of the proposals are worse than the status quo.
This column analyzes the potential interest rates in coming years under the key proposals—by President Barack Obama; Rep. John Kline (R-MN), whose proposal the House of Representatives approved today; and several proposals introduced in the Senate.
Determining student-loan interest rates
The goal of the student-loan program is to help increase access to postsecondary education, as education beyond high school remains critical for millions of students and their families as they seek to move into or remain in a part of the middle class. Recent reports from the Bureau of Labor Statistics now show that college graduates are nearly twice as likely to find work as those with only a high school diploma. An advanced degree provides individuals with a clear path to the middle class, a higher likelihood of gainful employment, and life-long financial and personal benefits. College education also provides for a skilled workforce that is crucial to rebuilding the entire American economy.
The best solution for determining student-loan interest rates is a long-term plan that is variable and would allow borrowers to take advantage of today’s historically low interest rates. A variable plan, however, must also include a cap that protects students against high interest rates in the future. Such high interest rates on student loans could discourage some students from enrolling and persisting in postsecondary education. The add-on interest rate amount should be as low as possible and avoid additional deficit reductions that shift the national debt onto students.
In addition, expanding protections such as Pay As You Earn—which lets borrowers limit their monthly payments to an affordable percentage of their income—to include all borrowers, along with the addition of a refinancing mechanism, would further strengthen the federal student-loan program. The PAYE expansion—outlined in the president’s budget for fiscal year 2014—would ensure that all federal student-loan borrowers could cap their monthly loan payments to 10 percent of their income so that the payments are affordable and achievable. A refinancing and loan modification mechanism would provide borrowers the option to switch their loans from their current interest rate model into the new system.
We recognize that a short-term fix may ultimately be necessary to prevent interest rates from increasing for subsidized student-loan borrowers. This is far from ideal, however, and Congress should only consider a short-term fix if competing priorities interfere with the passage of high-quality, long-term legislation. It is also critical that any savings needed to pay for the short-term fix should come from sources other than the federal student aid system.
Key variables
The first key variable is whether the interest rate should remain a fixed rate set by Congress or should instead become tied to a market variable that rises and falls according to market conditions. Fixed interest rates can quickly fall out of sync with the market, and this is especially unfair to students in the context of the historically low rates currently being provided for other forms of debt. Today, for example, a borrower can receive a 30-year fixed-rate mortgage at 3.6 percent or a 15-year fixed-rate mortgage at 2.75 percent—significantly lower than the rates of 6.8 percent and higher than student borrowers would have to pay in the absence of student-loan legislation.
An easy market variable to employ would be the rate the federal government pays for borrowing money. Since student loans are generally repaid in about 10 years, using the 10-year Treasury note, which currently has an interest rate around 2 percent, seems to be a straightforward option. Another option would be to use the 91-day T-Bill rate, the rate that the federal government pays for short-term borrowing, which is currently around 0.5 percent. The 91-day T-Bill rate, however, tends to be more volatile. A variable rate approach could be structured to have the rates for all loans made after July 1, 2013, change annually, or it could be used to determine the interest rate that would be fixed for all loans made that year.
The second key policy decision is to determine the level at which to set interest rates if they remain fixed—or what percentage of interest to add to the 10-year Treasury note or 91-day T-bill. This is known as the add-on and determines whether the student-loan proposal is budget neutral, costs money, or actually generates savings. By charging a higher interest rate, more money is generated, but students accumulate more debt. The lower the add-on or interest rate, the less debt the students accumulate.
Third, for variable-rate proposals, policymakers must decide whether to include a ceiling on which interest rates can be charged. This is to ensure that even if the variable that the interest rate was based on hit higher levels, such as 8 percent, the interest rate being charged to students could not surpass the given cap. This is an especially important protection for a complete variable model where the interest rate on all loans reset from year to year.
Fourth, some of the proposals also introduce various other protections to students or changes to the program that are more structural in nature—for example, including a refinancing provision to allow existing borrowers to move into the new interest rate model or expansions of repayment tools such as Pay As You Earn.
Primary student-loan interest rate proposals
There are three major proposals currently on the table regarding student loans that have been gaining momentum.
President Obama’s proposal
In his budget, President Obama used a variable model to determine loan rates at the point they are issued. After that time, the interest rate remains fixed for the duration of the loan. The president’s model also expands Pay As You Earn and sets the interest rate to the 10-year Treasury note plus an additional 0.93 percent for subsidized Stafford loans, 2.93 percent for unsubsidized Stafford loans, and 3.93 percent for PLUS loans, which are awarded to parents of students and to graduate school students. Under Congressional Budget Office projections, that would result in 2013-14 interest rates of 3.43 percent for subsidized Stafford loans, 5.43 percent for unsubsidized Stafford loans, and 6.43 percent for PLUS loans. It unfortunately does not include a cap on interest rates. The proposal is intended to be budget neutral and neither costs new money nor generates new savings.*
Rep. John Kline’s proposal
Rep. John Kline (R-MN), chairman of the House Committee on Education and the Workforce, recently put forth his own student-loan interest rate proposal. It is a completely variable proposal, meaning that the rates on all loans fluctuate from year to year. It is tied to the 10-year Treasury note, adds an additional 2.5 percent to both subsidized and unsubsidized Stafford loans, and adds 4.5 percent to PLUS loans. It also includes a fairly high cap on interest rates—8.5 percent for Stafford loans and 10.5 percent for PLUS loans. Unfortunately, the 2.5 percent and 4.5 percent add-ons are more than necessary and result in $3.7 billion in additional revenue, which would go toward paying down the federal debt. It does not include the PAYE expansion or a refinancing mechanism. Sens. Tom Coburn (R-OK) and Richard Burr (R-NC) have a similar proposal with a 3 percent add-on for all Stafford and PLUS loans. The Coburn-Burr proposal is more generous to the PLUS borrowers, however, than any other proposal.
Sen. Tom Harkin, Sen. Harry Reid, and Sen. Jack Reed’s proposal
Sen. Tom Harkin (D-IA), chairman of the Senate Health, Education, Labor and Pensions Committee, put forth legislation with Senate Majority Leader Harry Reid (D-NV) and Sen. Jack Reed (D-RI) to extend current student-loan interest rates for two years. The legislation, which has 20 co-sponsors, proposes that subsidized Stafford loans would remain at 3.4 percent for two years, and other interest rates would be unaffected. This legislation would cost $8.3 billion but is fully paid for through a package of three non-education offsets. This is designed to provide additional time to determine the best long-term solution through the reauthorization of the Higher Education Act.
Sen. Elizabeth Warren (D-MA) has also introduced a proposal that is a one-year plan to set subsidized Stafford loan interest rates at a lower rate than it is currently. She accomplishes this by tying interest rates to the Federal Reserve discount rate, which is the rate they charge their member banks for borrowing money. Sen. Warren is also a co-sponsor of the two-year extension.
Conclusion
Congress should move forward with a long-term solution that ensures students do not have to pay rates out of sync with the market and protects them from unmanageable debt. This long-term solution should not tax students to pay down the federal debt. If consensus on a long-term solution is unattainable in the next six weeks, however, Congress must act now and pass a short-term solution to prevent interest rates from doubling.
David Bergeron is the Vice President for Postsecondary Education at the Center for American Progress. Tobin Van Ostern is the Deputy Director of Campus Progress. Carmel Martin and Anne Johnson also contributed to this column.
* The Obama administration created its proposal based upon analysis of costs provided by the Office of Management and Budget and was designed to be budget neutral. It has been scored differently by the Congressional Budget Office as actually generating a savings. The administration has indicated that it intends to modify the proposal to make it budget neutral under CBO scoring rules.