Federal Student Loans

[The New America Foundation’s Education Policy Program on Tuesday released a comprehensive package of policy proposals that would provide an overhaul of federal financial aid. The report, Rebalancing Resources and Incentives in Federal Student Aid, calls for specific changes to grants, loans, tax benefits, college outreach programs and federal regulations to provide more direct aid to the lowest-income students, while strengthening accountability for institutions of higher education to ensure that more students are able to earn affordable, high-quality credentials. Yesterday, we explained why student aid reform is needed. In today's post, we provide an overview of our proposals.]

In Rebalancing Resources and Incentives in Federal Student Aid, we offer more than 30 specific policy recommenda­tions that are designed to create a streamlined federal student aid system that is more understandable, effective, and fair. Taken together, the package of proposals in our report is budget neutral over the 10-year period from federal fiscal years 2013-2022.

Pell Grants

The Pell Grant program is the cornerstone of federal stu­dent aid. In 1972, when the program was created, a Pell Grant covered most if not all college costs for large num­bers of low-income students. But as college prices have soared over the years, the system has become less and less effective. Moreover, the program is now facing a major “funding cliff” in the 2014 fiscal year and each year there­after.

[The New America Foundation’s Education Policy Program today released a comprehensive package of policy proposals that would provide an overhaul of federal financial aid. The report, Rebalancing Resources and Incentives in Federal Student Aid, calls for specific changes to grants, loans, tax benefits, college outreach programs and federal regulations to provide more direct aid to the lowest-income students, while strengthening accountability for institutions of higher education to ensure that more students are able to earn affordable, high-quality credentials. In today's post, we make our case for why student aid reform is needed.]

When Rhode Island Senator Claiborne Pell helped create the college student aid program that would become his legacy, American higher education looked very different than it does today. In 1972, the typical college student paid the equivalent of $526 per year in tuition and fees, in today’s dollars, to attend a public university in-state. Private college tuition was often affordable, and undergraduate borrow­ing was all but unheard-of. There were no “for-profit” colleges as we know them now. The large majority of all public support for higher education came in the form of direct appropriations to colleges and universities from states.

The world has changed since then. Profound shifts in the structure of the global economy have put a premium on high-skill jobs that require advanced credentials while many well-paying blue-collar jobs have disappeared. Students have flooded onto college campuses, in America and, increasingly, around the world. At the same time, col­leges and universities began a decades-long campaign in the early 1980s of constant price increases that continues, unabated, today. This happened in part because states, eager to cut taxes and facing rising costs for health care and public safety, reduced the portion of their budgets dedicated to higher education. At the same time, colleges competing for students and prestige ramped up spending year after year.

The Center for American Progress yesterday issued a preview of its upcoming proposal, which argues that Congress should allow people to refinance their student loans. The authors point out that the interest rate on the most widely-available federal student loan is a fixed 6.8 percent, but interest rates on other types of debt, like home mortgages and U.S. Treasury securities, are lower. Thus, they argue, borrowers with federal student loans should be able to take advantage of the lower rates. This line of reasoning is alluring, but it belies some key facts about federal student loans and lending markets in general.

First, no one with a federal student loan is barred from seeking out better terms elsewhere and refinancing their debt. In fact, the loans work exactly like home mortgages when it comes to refinancing. Borrowers are free to shop around for the best terms that a lender is willing to offer and use the proceeds from a new loan with better terms to pay off the old loan. Moreover, federal student loans never charge a “prepayment penalty” under which the borrower would be assessed a fee for paying off the loan early in a refinancing, or for any other reason.

Some might claim it is irrelevant that student loans and home mortgages can be refinanced in exactly the same way. After all, lots of lenders compete to refinance home mortgages, driving down interest rates in the market, but no such market exists for student loans. The lack of such a market, however, demonstrates a key point: The terms on federal student loans are still better than what private lenders offer. CAP’s proposal even notes that rates on private loans are twice as high as those on federal student loans. In other words, when it comes to federal student loans, borrowers already have the best terms available in the private market, and then some. What CAP and others must mean when they call for lower rates on student loans is that borrowers don’t have the best terms that the federal government can offer.

But that is a tricky argument to make. How does one measure what the government’s best terms ought to be? What should policymakers use as benchmarks, given that the terms on student loans are already the best available anywhere?

Like many observers, the Center for American Progress points to the interest rates on the government’s debt. Those rates are low and student loan rates are higher, the authors argue; therefore, borrowers should be able to refinance. That is an appealingly simple argument, but a deeply flawed one. 

Yes, banks make money when they borrow at a low rate and lend at a higher rate, but there is another essential component to that equation. Finance 101 teaches that it is theoretically impossible for anyone to borrow at a low rate and lend at a higher one unless someone also kicks in extra money to take the first loss. That extra money, the equity, acts like a buffer between the people from whom the bank is borrowing and the people to whom it is lending – and it is why the bank can borrow at a lower rate than it charges to lend the money out in the first place.

Most people are familiar with the concept of equity that takes the first loss, but may not realize it. When a bank issues a home mortgage, it requires the buyer to make a 20 percent down payment, which is equity. If home prices fall, the first 20 percent decline will be borne by the homeowner, not the bank. Similarly, when a bank borrows from someone at a low rate and relends that money out at a higher rate, the person who lent to the banks wants a similar buffer between his money and the loan the bank is making. It increases the chances he will be paid back.   

Equity, however, is obviously not free. That is why banks, who can borrow from depositors at rates as low as the federal government (the deposits are guaranteed by the federal government, after all) do not offer  loans at terms that beat those on federal student loans – especially when taking the non-interest rate benefits on federal student loans into account, such as universal eligibility, no credit or income checks, no co-signer requirements, income-based repayment with loan forgiveness, 30-year repayment plans, three-year forbearance plans, and unlimited in-school deferments. Despite being able to borrow at low rates, a bank lending at those terms would send its equity investors fleeing. 

When the federal government makes student loans, it is the taxpayers who act as equity holders. They are on the hook for any loss, since U.S. Treasury bondholders will always be paid back (debt ceiling debate notwithstanding). Therefore, arguing that interest rates on federal student loans should bear more resemblance to the low rates on U.S. Treasury notes implies that the federal government (i.e., the taxpayer) has no equity at risk in the transaction, or that the taxpayer is a source of free equity for the federal government. Neither is true.

The government’s cost to borrow is therefore an incomplete benchmark for calculating what the “break-even” interest rate on a federal student loan would be and determining whether rates are set too high. In other words, what investors demand when they lend to the federal government for 10 years is not what they would charge to lend to a student for 10 years. Even the most inexperienced investor knows that lending to the government is less risky than lending to a student.

Proposals for a federal student loan refinancing program boil down to this. Even though the federal government makes student loans at below-market rates and terms that no lender can beat, with protections galore for struggling borrowers, it could always sweeten the deal just a little bit more. But why should it? What is the goal, other than to slowly transfer money to people who meet no other metric of need other than the number in front of the percent sign on their student loan statement? There are indeed borrowers struggling to repay their loans, but ensuring that those borrowers are aware of and can easily enroll in repayment benefits that already exists seems like a much more targeted and far less costly way to deliver assistance.

Note: This post has been updated. The original version mischaracterized figures on the cost of IBR from the Barclays report.

In October the New America Foundation released Safety Net or Windfall, which explains how Obama administration changes to the Income-Based Repayment plan for federal student loans set to take effect this month dramatically expand the benefits the program offers, particularly to graduate students. Now Barclays has issued a report that measures just how big those changes will be.

The report, Student Loans: An Educated Mess, argues that the government has underestimated the cost of its student loan programs by $300 billion over the next 10 years, and the recent changes to the Income-Based Repayment program account for around $235 billion of that sum. Barclays projects that over half of all borrowers going forward will be eligible for the new IBR program, based on statistics reported by the Kansas City Federal Reserve Bank. The Department of Education believes enrollment will be just six percent.

Why such a big difference? Remember, when Congress first created IBR in 2007, the program was meant to provide a safety net to struggling borrowers. It sets a borrower’s payments at 15 percent of his monthly discretionary income, and any debt remaining after 25 years of payments in IBR would be forgiven. A borrower repaying through this “old IBR” program for a long period of time can incur substantial interest costs and pay a lot more on his loans over time, and even make higher monthly payments later, than if he repays under a non-income-based plan. Given those facts, coupled with IBR’s unwieldy enrollment process and a lack of awareness about the program, few borrowers opted in. Consequently, the Department of Education and budget agencies assume uptake will be similarly low going forward.

But those estimates ignore some big changes taking place. The Department of Education is improving the enrollment process and working hard to advertise the program. And now that a borrower’s payments are set to 10 percent of discretionary income, and loans are forgiven after 20 years, IBR will become a very attractive repayment option that has few if any downside financial risks for borrowers. In fact, new IBR is a large-scale tuition assistance program masquerading as a safety net, especially for graduate students who can take out federal loans to finance the full cost of their educations without limit.

Barclays has added more evidence to support that view. It won’t be long before the Congressional Budget Office and the U.S. Department of Education revise their cost estimates for IBR sharply higher. That should prompt lawmakers to rein in the benefits IBR provides while preserving the program’s safety-net function (see this Ed Money Watch post for how to do that). They can redirect those funds to more pressing student aid needs, like shoring up the Pell Grant program.

Senator Marco Rubio (R-FL) just announced that he paid off his student loans early with the proceeds from a book deal. Paying down debt ahead of schedule is generally a prudent financial move. But if the Obama administration’s new Income-Based Repayment (IBR) plan had been in place when Senator Rubio graduated from law school, his decision to pay down debt early would have been a sucker bet. Why pay early when your unpaid loans will be forgiven?

Read the full post on Ed Money Watch.

Senator Marco Rubio (R-FL) just announced that he paid off his student loans early with the proceeds from a book deal. Paying down debt ahead of schedule is generally a prudent financial move. But if the Obama administration’s new Income-Based Repayment (IBR) plan had been in place when Senator Rubio graduated from law school, his decision to pay down debt early would have been a sucker bet. Why pay early when your unpaid loans will be forgiven? That’s the financial choice countless graduate students will face in the coming years thanks to a now more-generous IBR plan that took effect on November 1, 2012, which is detailed in the New America Foundation report Safety Net or Windfall? Examining Changes to Income-Based Repayment for Federal Student Loans.

We estimate that if the New IBR plan were available back in 1996 when Senator Rubio started repaying his student loans, he would have $83,482 forgiven in the year 2015. We developed that figure using Senator Rubio’s actual income information, which has been released publicly since the year 2000. We estimate the Senator’s loan balance at graduation to be $170,000 based on a press article that indicates Senator Rubio had $165,000 in student loans in the year 2001, five years after he left school. We also approximated income information for the years 1996 through 1999 and after 2010 because actual information is not available. The calculation also factors in a family size of two in his first year of repayment (himself plus his wife) and increases in the years each of his four children are born.

The table above details what Rubio would pay under the Old IBR plan – the one that pre-dates the Obama administration’s changes last month. Under that plan, borrowers pay 15 percent of their incomes (subject to a cap) toward their loans annually after a “cost-of-living” exemption equal to 150 percent of the federal poverty guidelines. Any debt remaining after 25 years of payments is forgiven.

Under the plan that took effect on November 1, 2012, which we call “New IBR,” borrowers pay 10 percent of their incomes after the exemption, and have any debt forgiven after only 20 years of payments. Recent student loan borrowers are eligible for New IBR. (We adjusted the cost-of-living exemption in the calculator to reflect the initial 1996 poverty guidelines and annual increases thereafter. We also set the interest rate on the Senator’s loans to reflect those under current law, as that rate reflects the repayment terms under today’s program and illustrates what a borrower today would pay.)

Our paper exploring the New IBR system found that the plan will provide significant windfall benefits to high-income, high-debt borrowers—benefits that the Old IBR did not provide. Marco Rubio’s loan and income data offer a prime example. In spite of his salary, which at its high point nearly hits $400,000 a year, he would be eligible to receive more than $80,000 in loan forgiveness, and to pay substantially less than he would under the consolidation loan repayment plan that he actually used, if he graduated today.

This is yet more proof that policymakers must amend the program to rein in its benefits and the incentives it provides to graduate and professional schools to raise tuition. Our paper outlines exactly how policymakers could accomplish that while preserving the safety-net function of IBR – and under that plan, Senator Rubio would receive no loan forgiveness, but would still pay far less than under consolidation. That’s a good deal for students.

So far, the Obama administration hasn’t said a word about the serious flaws of New IBR, and hasn’t stated whether it has any intention of addressing them. Maybe Senator Rubio can help the White House understand the issue. He could start by explaining to the President why a government check for $83,482 to forgive his student loans (or someone like him) isn’t the best use of taxpayer money.

Morehouse, a private, all-male, liberal arts college, is one of the most prestigious historically black colleges in the nation. With a mission to develop men with disciplined minds who will lead lives of leadership and service, and a notable alumni list that includes Dr. Martin Luther King, Jr., Morehouse attracts some of the best and brightest. So why has this esteemed, selective institution of higher education suddenly been forced to furlough faculty and staff? The answer proves to be both surprising and unsettling: Parent PLUS Loans.

As I’ve written here before, Parent PLUS loans have increasingly become a burden for many families. While the federal government issues these loans, they are most similar to private loans and require parents to pay a high, fixed interest rate of 7.9 percent (plus a 4 percent origination fee, for a total APR of about 9 percent). Parents borrow these loans on behalf of their college-going children, and must meet minimal standards to qualify (more minimal than for private loans).  Unlike federal Stafford or Perkins loans, there is no cap on PLUS loans. Parents may borrow up to the full “Cost of Attendance” (COA) of the institution.

Here’s the problem: Morehouse is expensive. Its COA for 2011-2012 was around $44,000. Even when taking into account federal, state, and institutional financial aid, its average net price was $23,324. For students from families with incomes at or below $30,000, the net price was $23,036. Think about that. Some families are paying more than what they make in one year to send their children to Morehouse.  And Morehouse attracts a significant percentage of low-income students—almost 50 percent receive Pell Grants.

Back in 2010, the National Commission on Fiscal Responsibility and Reform (aka the Simpson-Bowles commission) recommended as part of its deficit and debt reduction proposal that policymakers end the interest-free benefit on Subsidized Stafford student loans. These loans are a subset of student loans awarded to borrowers who meet an income and cost-of-attendance formula test. The proposal was met with howls from student and borrower advocates who rushed to point out that students would leave school with more debt if policymakers eliminated the interest benefit, which stops the interest clock while borrowers are enrolled in school and, in some cases, for up to three years after.

Nevertheless, upon the request of the Obama Administration, Congress ended the benefit for graduate students in 2011, and moved the money to Pell Grants. That left the benefit intact for undergraduates, but probably not for much longer. It costs a whopping $4 billion a year, while the Pell Grant needs an extra $5.8 billion next year and $8.9 billion the following year to stave off a cut in benefits.

If lawmakers end the Subsidized Stafford interest benefit for undergraduates to provide more funding for Pell Grants—and they should—expect student and borrower advocates to again argue that the changes will increase student debt burdens. Except this time, the critics will have to include a big caveat that will undermine their case.

Subsidized Stafford loans now provide regressive benefits. That is, they target benefits to borrowers earning higher incomes in repayment. That is due to the new Income-Based Repayment (IBR) plan for federal student loans that took effect this month.  

The new plan (“New IBR”) sets a borrower’s payments at 10 percent of discretionary income and forgives any debt after 20 years. Those benefits effectively make Subsidized Stafford loan benefits redundant for borrowers who earn a lower or middle income in repayment.[1] Borrowers earning higher incomes, on the other hand, will still earn benefits from Subsidized Stafford loans in the form of reduced total payments.

Here is another way to understand this point. Borrowers will leave school with higher loan balances if policymakers eliminate the interest-free benefit on Subsidized Stafford loans. However, borrowers’ monthly and total payments under IBR are based on their incomes, not loan balances, and because the repayment term is set at 20 years (loan forgiveness) regardless of loan balance, New IBR ensures that the only borrowers who make higher payments as a result of having a higher loan balance are those with higher incomes.  

At what income level does this matter? There isn’t a magic number, but undergraduates are limited in how much federal loans they can take out. That allows us to run scenarios through the New America Foundation IBR calculator and see what borrowers will pay on their loans based on set income profiles, with and without the interest-free benefit on Subsidized Stafford loans.[2] The results are displayed in the table below.

In this analysis, we first assume the borrower’s debt is the maximum amount that a dependent undergraduate can borrow if he is 1) eligible for the full amount of Subsidized Stafford loans, plus the remaining amount of Unsubsidized Stafford loans, plus accrued interest while in school or 2) if he is eligible only for Unsubsidized Stafford loans plus accrued interest. The resulting loan balance at graduation after five years of borrowing under the first option is therefore $33,448, of which $23,000 is in Subsidized Stafford loans; and under the second, is $39,296, all in Unsubsidized Stafford loans.

Next we developed five borrower profiles, each with a different starting income and income growth rate. Borrower 1 has a starting income of $22,000 that increases by three percent every year, up to $38,577 in year 20. Borrower 2 has a starting income of $40,000 that increases by three percent every year, ending at $71,400 twenty years later. Borrower 3 has a starting income of $25,000 that increases by nine percent annually, reaching $128,542 in year 20. Borrower 4 has a starting income of $50,000 that increases by three percent every year, ending at $87,675 in year 20. Borrower 5 has a starting income of $40,000 and increases six percent each year, reaching $121,024 after twenty years.

As the table shows, under New IBR, the only borrowers who benefit from the additional benefits of Subsidized Stafford loans are those who earn a middle income right out of school, or those who eventually make a high income. Even then, the borrowers reap the benefit of a Subsidized Stafford in their last payments, not in their first years out of school. Their payments under IBR are based only on their incomes, not their loan balance, loan type or interest rate.

This brings up another key point. Not only are the added benefits of a Subsidized Stafford loan regressive, but borrowers earn the benefits in the form of a shorter repayment term—their final year(s) of repayment. Therefore, they collect a benefit when they theoretically are most able to repay.[3]

In short, with the availability of New IBR, Subsidized Stafford loans provide no additional aid to borrowers who need it most, while reducing payments for borrowers who are not struggling to repay. That should help persuade lawmakers and the student aid advocacy community that it would be prudent policy to end the Subsidized Stafford benefit and use the money instead to aid lower income college students through the Pell Grant program. The New IBR plan is now by far the most beneficial repayment plan available to low-income borrowers, so much so that it renders other, more poorly targeted benefits obsolete.

President Obama should include that policy proposal in his forthcoming budget request to Congress, citing the benefits of his administration’s New IBR as the justification for ending Subsidized Stafford loans.

There’s another lesson in here, too. Federal student aid is an incoherent mix of complex benefits and rules that overlap and cancel each other out in ways that virtually no one understands. For that we may thank the lawmakers (and the advocates who encourage them) who have added to, tweaked, and changed eligibility rules for these programs time and time again without even a hint of a broad plan. It’s time for a wholesale redesign of federal student aid.  

Now that President Obama has been reelected, and he has more time to sit back and read Higher Ed Watch, we are presenting our wish list for his second term. [And Mr. President, while you're at it, we're sure you'll enjoy our posts from last week highlighting your first term's biggest higher education hits and misses!]

Among other things, we (the authors of this post) would like to see the Obama administration do the following:

• Hold college accountable for reigning in college costs and improving student outcomes. The administration must be willing to take on the entrenched and powerful institutional interests of traditional colleges.

• Develop long-term solutions for revamping the federal financial aid programs, rather than continuing to scramble to come up with stop-gap measures to shore up funding for these programs in the heat of high-stakes budget battles.

• Finalize the financial aid shopping sheet and scorecard—and make them mandatory. Students and families need clear, consistent, useable information at key points in their decision-making process. Given that many institutions currently benefit from the lack of this information, voluntary adoption of these efforts will accomplish very little.

Last week, the Obama administration finalized regulations for Pay-As-You-Earn (PAYE). The program is an update to the existing Income-Based Repayment (IBR) plan, and it allows federal student loan borrowers to pay ten percent of their income every month and receive loan forgiveness after 20 years, changed from 15 percent of borrowers’ monthly incomes and 25-year loan forgiveness under the old version of IBR. The Federal Education Budget Project released a report last month demonstrating that PAYE will provide windfall benefits to graduate and professional students, even if they end up earning a high-income.

Jason Delisle, director of the FEBP and co-author of the report, spoke with Businessweek about the problems with the new program – and how it is a boon to graduate students, even those earning six-figure salaries by the time they receive loan forgiveness. 

An excerpt of the interview is below. Click here to read the full interview.

Businessweek: Based on your findings, what would you tell students thinking about graduate school or getting an MBA? What is the best way for them to take advantage of this program?

Delisle: My advice to people who are about to enter graduate school or get an MBA would be to borrow as much money as they possibly can through the federal student loan program. They shouldn’t use their own money, savings, or income to pay for it because the risks or the downside of this having real financial consequences for you, provided this program is in place, are almost zero. And to the extent that there are risks, they are well worth taking because the potential upside is pretty big on this.

Businessweek: … Do you fear this will encourage graduate schools to raise their tuition, especially lower-tier schools?

Delisle: You can imagine schools that are having problems enrolling students or getting them to pay tuition hiring financial planners to come on campus and do seminars. They’ll be able to tell them, Here is why you don’t have to worry about how much you are borrowing to pay for school, or here’s why you don’t have to worry if you don’t land a great job. This is money coming in the door for the schools and none of it is far-fetched. Some of this stuff looks like shady infomercial stuff, but it is a real program that is about to take effect.

Read the full report here.