Federal Student Loans

Note: This post was updated on 02/02/2012 with new cost estimate information.

Last week President Obama called on Congress in his State of the Union address “to stop the interest rates on student loans from doubling in July.” That line surely left a lot of people (Washington’s education policy circles not included) wondering what in the world the president was talking about. Is Congress really planning to double the interest rate on federal student loans this summer? The answer is yes, no, and maybe. In other words, it’s complicated. What’s more, a newly released estimate from the Congressional Budget Office shows that the cost of the president’s request will weigh heavily in any debate on the proposal.

Interest rates on Unsubsidized Stafford student loans, which are federal loans available to all students, issued for this academic year (2011-12) are fixed at 6.8 percent. The same rate has been charged on these loans issued since July of 2006. However, the interest rate is fixed at 3.4 percent for a subset of federal student loans – Subsidized Stafford loans for lower-income undergraduate students – issued this academic year. That rate is only temporarily available, and beginning in the 2012-13 academic year, the rate on that subset of loans will be the same as for Unsubsidized Stafford loans, 6.8 percent. So yes, rates are set to double for newly issued loans made to a subset of undergraduates after July 1, 2012.

The seeds for the coming rate change were planted way back in 2006. In their 2006 campaign platform, A New Direction for America, House Democrats promised to “slash interest rates on college loans in half to 3.4 percent for students and to 4.25 percent for parents.” By the end of 2007, they had (technically) made good on their promise. But just like those credit card offers that promise a low interest rate, the rate cut was enacted with important details listed only in the fine print.

Once lawmakers realized that their campaign promise would, according to the Congressional Budget Office, cost $133 billion over ten years (a substantial sum), they opted to scale it back dramatically. That’s where the fine print comes in.

To reduce the cost of the rate cut, Congress cut rates in half only for a subset of loans – Subsidized Stafford loans – which are available only to borrowers from families with middle and lower incomes. While graduate and undergraduate students were previously eligible for Subsidized Stafford loans, the law made only undergraduate students eligible for the rate cut. It left rates unchanged for the larger Unsubsidized Stafford loan program as well as for PLUS loans for parents and graduate students despite their inclusion in the campaign pledge. Even so, those caveats still didn’t get the cost of the proposal down to the size lawmakers wanted.

So to further reduce costs, Congress slowly phased in the interest rate cut over four years and then turned it off such that only loans issued for the 2011-12 school year would carry rates of 3.4 percent (half of 6.8 percent). Subsidized Stafford loans issued to undergraduate students after that year would again carry a fixed rate of 6.8 percent. In short, the 2007 law “cut interest rates in half” for loans issued only this academic year – and only for certain undergraduate students.

As President Obama demonstrated in his address last week, the rate cut issue will loom large this election year and Congress will be under a lot of pressure to stave off the rate hike. Of course, if lawmakers thought the 3.4 percent rate was too costly to make permanent back in 2007 at $3.0 billion a year, it won’t be any cheaper to do it this time around. In fact, it will be a lot more expensive. An early estimate from the Congressional Budget Office says extending the rate cut for one year will cost about $5.9 billion and $45 billion to extend it for ten years.

That’s why President Obama has requested only a one-year extension of the rate cut. Sadly, that’s exactly the type of shortsighted policymaking that got us here in the first place.

In the Budget Control Act of 2011 (aka the debt ceiling agreement) Congress provided the latest round of supplemental funding for the Pell Grant program. The law included $10 billion for fiscal year 2012 for the program and another $7 billion for fiscal year 2013. The law offset the cost of that one-time supplemental funding by eliminating a type of federal student loan available to graduate and professional students — Subsidized Stafford loans. These loans will no longer be issued to borrowers as of July 1, 2012. While this is old news to some, it’s come to our attention that Ed Money Watch posts and Federal Education Budget Project issue briefs do not fully explain an important nuance in what this policy change means for graduate students. Let’s set the record straight.

Click here to read the full post on Ed Money Watch...

In the Budget Control Act of 2011 (aka the debt ceiling agreement) Congress provided the latest round of supplemental funding for the Pell Grant program. The law included $10 billion for fiscal year 2012 for the program and another $7 billion for fiscal year 2013. The law offset the cost of that one-time supplemental  funding by eliminating a type of federal student loan available to graduate and professional students — Subsidized Stafford loans.  These loans will no longer be issued to borrowers as of July 1, 2012. While this is old news to some, it’s come to our attention that Ed Money Watch posts and Federal Education Budget Project issue briefs do not fully explain an important nuance in what this policy change means for graduate students. Let’s set the record straight.

Since the early 1990s, federal student loans have been available to borrowers regardless of family income. This includes undergraduate, graduate, and professional students. In earlier years, only middle and lower income families qualified for federal student loans, and the federal government did not charge interest on these loans while borrowers were enrolled in school. When Congress opened up the loan program in the early 1990s to effectively all students regardless of income, lawmakers maintained the in-school interest-free benefit for lower to middle income borrowers but did not offer this benefit to higher income borrowers.  Interest on loans issued to higher income borrowers accrues (but does not compound) while the borrower is in school. The loans with the interest benefit are called Subsidized Stafford loans and those without are Unsubsidized Stafford loans.

When Congress eliminated Subsidized Stafford loans for graduate students last year, most reports of this policy change (including ours at Ed Money Watch) explained that graduate students will lose the “in-school” interest benefit on loans issued on July 1, 2012 and later. But borrowers of Subsidized Stafford loans received additional benefits beyond the in-school subsidy, and few reports have mentioned that these benefits have also been eliminated – borrowers qualified for an interest-free benefit during the six months after leaving school (the so-called grace period interest benefit) and under any deferment period, including the three-year deferment periods for unemployment or economic hardship.

What is more, Subsidized Stafford loans provide an important benefit under the Income Based Repayment plan that Unsubsidized Stafford loans do not.  A borrower with Subsidized Stafford loans who does not pay enough each month to cover the interest on his loans (“negative amortization”) has this unpaid interest forgiven. Subsidized Stafford loan borrowers are eligible for this benefit for up to three years of repayment.  The federal government does not forgive this unpaid interest for borrowers with Unsubsidized Stafford loans, meaning their loan balances can grow while using Income Based Repayment.  (It’s interesting that the Obama Administration has fought to make the Income Based Repayment plan more generous for borrowers but simultaneously supported eliminating the Subsidized Stafford loans for graduate students, which makes Income Based Repayment far less generous for these borrowers.)

In short, eliminating Subsidized Stafford loans for graduate students means more than the loss of the in-school interest-free benefit. It includes the loss of a whole host of interest-free benefits for graduate students that would have received subsidized loans. These benefits helped lower costs for borrowers not just while they were in school, but during periods when they needed to delay (deferment) or reduce (income based repayment) repaying their loans.  For some students, those out-of-school interest benefits may have been worth more than the in-school portion, and they should be included in any analysis of the effects the elimination of Subsidized Stafford loans will have on graduate students. Moreover, policymakers and education advocates should keep this more complete explanation of the interest benefit in mind as they debate any proposal to end the still-available benefit for undergraduate students.

The Asset Building Program and the Center for Social Development at Washington University in St. Louis (CSD) are pleased to publish a series of reports collectively titled "Creating a Financial Stake in College." Authored by William Elliott III, professor at University of Kansas School of Social Welfare, the four-part series focuses on the relationship between children's savings and improving college success.

Congress is finally poised to vote on an omnibus spending bill that covers multiple federal agencies and finalizes fiscal year 2012 funding for the U.S. Department of Education. The bill, which is posted on the House Rules Committee’s website here, is expected to pass. As we wrote earlier this week, the pending omnibus bill funds the Pell Grant program at a maximum grant of $5,550 in part by tweaking  eligibility rules for the program and by reallocating subsidies for student loans.  That latter provision was part of a Senate proposal floated earlier this year and has undergone a rather odd mutation in the final bill.

Specifically, the provision ends the interest-free benefit on Subsidized Stafford loans during an undergraduate borrower’s six-month grace period after leaving school. This change produces savings that the pending bill then reallocates (spends) to Pell Grants in 2012 and subsequent years. The version proposed by Senate Democrats earlier this year would have permanently ended that benefit on all newly issued loans, generating some $2.9 billion in savings over five years and $6.1 billion over ten years. All of those savings would have been allocated to Pell Grants, though not all in 2012. 

The provision in the omnibus appropriations bill Congress is set to vote on also ends the grace period interest benefit, but only for loans issued between July 1, 2012 and July 1, 2014. Loans issued after those dates would again qualify for the benefit. A temporary repeal of the benefit saves only about half as much over five years as a permanent repeal and saves nothing in later years. Subsequently, it allows for less spending to be reallocated to Pell Grants.

From a student’s point of view, the pending change is likely to sow a bit more confusion in an already-confusing set of loan terms and repayment rules. For example, a borrower who begins a four-year program in 2012 and borrows only Subsidized Stafford loans will have some loans that qualify for the 6-month grace period benefit and some that do not.

Some observers will defend the temporary repeal of the interest-free benefit as a way to get just enough savings to shore of the Pell Grant program in the near term without reducing student loan benefits any more than necessary in future years. In other words, the policy is meant to take only what is immediately needed. It’s also likely that the Senate proposed to repeal the interest benefit reluctantly earlier this year, and probably felt it had to pull back from a full repeal after conceding to the House on some Pell Grant eligibility changes in the final omnibus bill.

Regardless of the negotiating strategy, or how the short term funding compromises stacked up, the temporary repeal is bad policy. Congress should either leave it as is, and find savings to support Pell Grants elsewhere, or repeal it permanently. Besides, Congress is going to need all of the savings from a permanent repeal, and then some, when the temporary emergency funding for Pell Grants (including the 2009 stimulus, the 2010 Student Aid and Fiscal Responsibility Act, the repeal of year-round Pell Grants, and the 2011 Budget Control Act) finally comes to an end.

In 2014, Congress will need to appropriate some $31 billion to maintain the maximum Pell grant. That will make this year’s heroic effort to appropriate $22.5 billion feel like a very light lift. Congress should do what it can now to shore up the Pell Grant program for the long term.

The Joint Select Committee on Deficit Reduction (the supercommittee), which is charged with finding ways to cut the budget deficit over 10 years by at least $1.2 trillion, looks set to miss its deadline. The Budget Control Act of 2011, the law that increased the debt ceiling and created the supercommittee, set November 23rd as the date by which the committee must vote on a deficit cutting bill. With two days to go, no such vote is expected to happen. What might become of federal education programs in the wake of a supercommittee failure?

Today the Washington Post highlighted key K-12 education programs that would see their fiscal year 2013 funding trimmed in the absence of a supercommittee compromise. But the article doesn’t mention federal programs for higher education. Make no mistake, higher education programs, like Pell Grants and student loans, would also be affected by a supercommittee failure.

To read this complete post on Ed Money Watch, click here.

This week everyone has been talking about student loans. The Obama administration announced some minor changes to the Direct Loan program. Separately, the House Education and Workforce Committee held a hearing to examine the program’s performance since Congress ended the bank-based guaranteed loan program last year. At the same time, some “Occupy Wall Street” protestors have been demanding relief from student loans. With all this attention on federal student loans, the direct-loans-are-profitable-for-the-government argument has been out in full force.

For example, at the House hearing Rep. John Kline (R-MN) said an interest rate of “6.8 percent when the federal government is borrowing at less than 1 percent can create a pretty big slush fund.” Democrats on the committee agreed with Kline that the government is earning money off of the program but argued lawmakers should consider lowering the interest rate that students pay to no more than what it cost the government to borrow and pay for loan defaults.

Generally, liberals, student advocates, and lobbyists for colleges say that Direct Loan profits suggest that the government is “overcharging students.” To conservatives and student loan companies, Direct Loan profits mean the government is competing with private businesses in providing a for-profit service.

Those would all be valid arguments except for the fact that the Direct Loan program doesn’t make money and it isn’t profitable.

This week everyone has been talking about student loans. The Obama administration announced some minor changes to the Direct Loan program. Separately, the House Education and Workforce Committee held a hearing to examine the program’s performance since Congress ended the bank-based guaranteed loan program last year. At the same time, some “Occupy Wall Street” protestors have been demanding relief from student loans. With all this attention on federal student loans, the direct-loans-are-profitable-for-the-government argument has been out in full force.

For example, at the House hearing Rep. John Kline (R-MN) said an interest rate of “6.8 percent when the federal government is borrowing at less than 1 percent can create a pretty big slush fund.” Democrats on the committee agreed with Kline that the government is earning money off of the program but argued lawmakers should consider lowering the interest rate that students pay to no more than what it cost the government to borrow and pay for loan defaults.

Generally, liberals, student advocates, and lobbyists for colleges say that Direct Loan profits suggest that the government is “overcharging students.” To conservatives and student loan companies, Direct Loan profits mean the government is competing with private businesses in providing a for-profit service.

Those would all be valid arguments except for the fact that the Direct Loan program doesn’t make money and it isn’t profitable.

The Direct Loan program issues about $100 billion in new student loans each year with over $500 billion in loans currently outstanding. The program charges undergraduates fixed interest rates between 3.4 percent and 6.8 percent. Graduate students get the same rates, but can borrow additional amounts at 7.9 percent interest rates under the Grad PLUS program. All students qualify for at least some type of loan regardless of their financial need. Repayment plans can be as long as 30 years and borrowers experiencing “economic hardship” can postpone payments for up to three years under deferment and forbearance policies, or can repay under income-based repayment plans. The government also forgives loans under a number of circumstances.

It’s common knowledge that banks make money by borrowing at low interest rates and making loans at higher rates. In the most basic sense that is a fair characterization. Many people therefore assume that Direct Loans are profitable for the government because the fixed interest rates borrowers pay are twice as high (or more) as what it costs the government to borrow.

But if the profitability of the loans is simply equal to the difference between these two interest rates, why don’t private banks make student loans at the same terms as the government? They can borrow at low rates too.

Take a look at the interest rate banks pay on savings accounts. It’s less than a third of a percent. A ten-year certificate of deposit pays 2.5 percent interest. Those rates are pretty close to U.S. Treasury rates, and they should be – bank deposits are insured by the federal government. They are certainly lower than the interest rate the government charges on student loans. But you won’t see your local non-profit credit union offering terms as good as a federal Direct Loan. That is because banks believe making loans at those interest rates and with those types of repayment plans is too risky relative to what the bank can expect to get in return. In other words, private banks are not willing to take on the risk associated with these loans at such low interest rates.

Of course, there are far more technical and complicated ways to explain why Direct Loans don’t make money, but we will leave those for another time. For now, take it as proof that not even the most efficient, most profitable banks in the country make loans as generous as those in the Direct Loan program because it is a money-losing endeavor.

It’s not bad, however, that the loans don’t make money. They aren’t supposed to. In fact, the government’s loss on the loans serves as a subsidy for the student who borrows to pay for school. According to a 2010 Congressional Budget Office study(page 10), the typical student gets a 12 percent subsidy on his federal Direct Loan. Put another way, the borrower receives a government benefit worth 12 percent of the amount he borrows. A $5,000 loan, therefore, provides a $600 government benefit to the student.

Regardless of these facts, any debate about federal student loans will inevitably be based on the false premise that the loans are profitable for the government. When the interest rate on subsidized Stafford loans jumps from 3.4 percent to 6.8 percent next school year, you can be sure there will be cries of usury. And as the Obama administration makes the case that the incentives it offers students to switch their loans over to the Direct Loan program save money overall, you can be sure some lawmakers will claim all of those savings come from profits earned off of students. Neither argument is true.

President Obama announced on Wednesday that the U.S. Department of Education will encourage millions of student loan borrowers to convert loans they borrowed through the Federal Family Education Loan (FFEL) program into direct lending. At Higher Ed Watch, we are pleased that the administration is moving ahead with this plan, which aims to help borrowers who are stuck with student loans under both the FFEL and Direct Loan programs.

The initiative, which will get underway in January, will provide some savings to borrowers who take advantage of it by providing them with up to a 0.5 percent interest rate reduction on their federal loans. But the administration's primary purpose is to simplify the repayment process for borrowers who currently have to make payments on their federal student loans to multiple loan servicers each month.

As readers of Higher Ed Watch know, the Democratically-controlled Congress last year eliminated the FFEL program and shifted to 100 percent direct lending. While the transition has gone remarkably smoothly, nearly six million borrowers have found themselves with loans in both programs, creating an administrative burden for these individuals, as well as for colleges and the federal government.

Many of the reporters who covered yesterday's House of Representatives hearing on the Direct Student Loan program appear to have missed the main story: the utter failure of the Republican leaders of the House Committee on Education and the Workforce to make their case that the U.S. Department of Education has mismanaged the transition to 100 percent direct lending.

In fact, by the end of the two-hour hearing, the House committee’s leaders were forced to acknowledge the Education Department’s success in shifting thousands of colleges out of the Federal Family Education Loan (FFEL) program and into direct lending without any meaningful disruption in service.

“I am glad to see that the transition has gone pretty well,” the education committee’s chairman John Kline (R-MN) said. At the conclusion of the hearing, Rep. Virginia Foxx (R-NC), the chairwoman of the panel’s higher education subcommittee, commended the Education Department “for what it’s done.”

This was a remarkable reversal, considering that the original intention of the hearing -- which was entitled “Government-Run Student Loans: Ensuring the Direct Loan Program is Accountable to Students and Taxpayers" -- was to bash the Education Department.