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Bipartisan Deal to Reduce Deficit on Backs of Student Borrowers

posted by Alan White

Congress and the President are making huge decisions about the future of our biggest consumer credit markets – mortgages for homebuyers and college loans for students.  Unfortunately critical policy choices are being avoided, ignored, or obfuscated.  I’ll comment on student loans in this post, housing finance reform in a future post.

The student loan bill about to be signed by the President is touted as “reducing” interest rates for students.  This is nonsense. The “reduction” is only from the jacked-up rates that went into effect a few weeks ago on July 1 because of a prior legislative gimmick.  The basic undergrad student loan rate of 3.4% was scheduled to go up to 6.8% on July 1 mostly so that the federal deficit over multiple years would appear smaller in out years.  Most observers assumed that the rate hike would not happen, but deficit hawks used this gimmick as another pressure point to advance their agenda.  If you compare interest rates before July 1 with rates being charged under the new law, students are paying more interest, not less.  The CBO scores the bill as reducing the federal deficit by about $700 million.  Instead of a fixed 3.4%, students will pay 3.9% this year, and the 10-year Treasury bill rate plus 2.05% in future years.  Graduate students will pay much more (and are lower credit risks.)

More problematically, the “rate reduction” bill continues a practice, never fully debated, of using student loan interest as a profit center for the federal Treasury. The student loan Treasury profit is a consequence of the Clinton Administration’s Direct Loan program.   Under that program, instead of subsidizing banks to fund student loans, the Treasury lends money directly to students (albeit through private servicing contractors).  In the 1990s, banks and their Congressional mouthpieces vigorously disputed the proposition that direct Treasury lending would be cheaper than the old system of subsidizing the banks to fund student loans.  Not only were they wrong, but they were so wrong that the same interest rates that had to be subsidized when offered by banks produced a net profit to the Treasury under the Direct Loan program.  For many years, Congress was not willing to offer cheaper interest rates on Direct Loans than on bank loans, so the Direct Loan borrowers effectively subsidized the guaranteed bank loans.  The fact that the government could be the low-cost provider was just too mind-blowing for the Washington consensus.  In recent years, it has been convenient for Congress to ignore the fact that Direct Loan student borrowers pay much higher interest rates than are necessary to cover the costs of the program.

Senator Warren has proposed pegging student loan rates to the low rates paid by banks borrowing from the Federal Reserve.  This is an interesting idea, but it seems to me we should begin with the proposition that students pay no more interest than is needed to cover the cost of the student loan program, i.e. that we run it as a break-even operation rather than a money-maker for the Treasury. 

Here is the Senate vote on the bill, and here is the House roll call.


I couldn't agree more. My daughter is going into high school this year and when I look at the projections for the rate she and her classmates are likely to pay, I am appalled. This only contributes to the problem of higher education that is out of reach for many, and it is poor public policy as well.

Unfortunately, students (and their parents) don't realize what they are up against until it's too late and they are struggling to repay their debt.

It is not clear to me why interest rates for all undergraduate loans, or all graduate loans should be the same. An argument could be made for setting rates that reflect the differing credit risks (and expected collection costs) of each borrower. I suspect that an objective measure of such credit risk would be affected by the individual's credit history, but also by the institution at which they are studying and the program they are following. If we decide for whatever reason that we do not wish to charge differential interest rates, at the very least, I would welcome greater transparency of the level of cross-subsidy between the various classes of borrowers.

Something need to get done to help these students out. This problem is quickly becoming a serious problem.

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