Ed Money Watch

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.

Congress pulled the country back from the edge of the fiscal cliff late Tuesday night when the U.S. House of Representatives voted to pass an agreement urgently negotiated and passed by the Senate on New Year’s Day. The agreement, set to become law this week, addresses some, but not all, of the policies that make up the fiscal cliff. It deals mainly with expiring tax policies, but only postpones for a few weeks the automatic spending cuts set to take effect on January 2 and does not increase the limit on the national debt. The pending law – titled the American Taxpayer Relief Act of 2012 – extends or makes permanent a number of tax benefits for education.

Few observers outside of Washington understand the extent to which Congress and the president make education policy through the tax code. Exemptions, credits, and deductions now account for over $30 billion a year in “spending” (in the form of forgone revenue) for education, mostly for postsecondary education. But a good portion of that spending was set to expire or had already expired at the end of 2012. With the passage of the American Taxpayer Relief Act of 2012, those policies are here to stay for a few more years, or in some cases permanently. (The table below lists the expiring policies and the pending extension.)

The largest of these tax expenditures related to education, the American Opportunity Tax Credit, was set to expire at the end of 2012 and revert to the less-generous Hope Credit. Instead, it has been extended for five years, through 2017, at a $67.3 billion 10-year cost to taxpayers. Other tax expenditures, including Coverdell education savings account benefits, employer-provided educational assistance, and the student loan interest deduction, were permanently extended. Those three combined will cost more than $21 billion over 10 years.

Two other education tax expenditures – the classroom expenses deduction for K-12 teachers and the deduction for qualified tuition and related expenses for postsecondary students and their families – were extended through 2013 after both deductions lapsed at the end of 2011. The short renewal Congress afforded to them this week means lawmakers have set themselves up for another fight over the deductions at the end of the 2013 calendar year.

Moreover, the deal Congress produced failed to answer other questions. Sequestration, the across-the-board cuts to virtually all programs scheduled to occur on January 2, 2013, for example, remains unresolved. Instead of either implementing the cuts this month or cancelling the threat of sequestration, the cuts have been delayed until March 1, 2013. That’s just a few weeks before the short-term continuing resolution, under which the federal government is currently operating at fiscal year 2012 funding levels, expires.

And according to the Treasury Department, the U.S. hit the debt ceiling – its borrowing limit – on Monday. Treasury Secretary Tim Geithner said the Department would engage a set of “extraordinary measures” to buy time, giving lawmakers until late February to act.

All this means the fiscal cliff agreement is really just a short respite on the way to the next fiscal cliff, scheduled to hit again in just a few months. Admittedly, the next agreement may be slightly easier to reach, given that it will occur under a new Congress with more Democrats in both houses (though leadership will still be split, with a Democratic Senate and a Republican House), and the biggest tax issues are now settled. But the circumstances haven’t changed, at least on the spending side. School districts are still at risk of losing significant federal funding (estimated at 8.2 percent per federal program, across the board). And Congress faces yet another knock-down, drag-out fight over spending levels and deficit cutting.

Rumors swirling around Washington, D.C. suggest President Obama and Speaker of the House John Boehner are close to reaching a deal to head off the expiration of current income tax rates and across-the-board spending cuts scheduled for January 2013. This is the dreaded “fiscal cliff.” But if they can’t reach a deal soon, the effects will be felt at public schools across the country – particularly at so-called “federally impacted” schools. Using data published annually by the National Association of Federally Impacted Schools (NAFIS), we calculated the anticipated effects of the across-the-board cut on those 1,238 school districts. (Click here to download our calculations.)

Before diving into those figures, let’s review how we got to the fiscal cliff. Under the Budget Control Act (BCA), which lawmakers passed in August 2011 as part of a bipartisan deal to increase the federal debt limit, a Congressional supercommittee was charged with developing policies that would reduce the budget deficit by more than $1 trillion over ten years. Predictably, they failed to reach an agreement on what those policies would be. So the BCA’s backup plan was triggered.

The first part of the backup plan reduced annual spending caps for appropriations funding for the next ten years. The caps effectively reset that portion of the federal budget about 2008 levels. And because of a timing quirk (fiscal year 2013 began in October, but the caps aren’t put in place until January 2, 2013), 2013 appropriations are to be reduced retroactively by across-the-board mid-year rescissions, known as sequestration. The Office of Management and Budget estimates that the sequesters will reduce funding by 8.2 percent per domestic discretionary program, compared to prior year funding.  (Pell Grants and school nutrition programs are exempt). For schools, this means an 8.2 percent cut to virtually every federal program (Race to the Top, Title I, special education grants) from which they receive funds. 

Another timing quirk will, however, delay the cuts until early 2014 for most schools. Big federal education programs like Title I grants to school districts for economically disadvantaged students ($14.5 billion in FY2012) and special education state grants ($11.6 billion in FY2012) are mostly funded a year ahead of time through advance appropriations, which means they were allocated their 2013 funds too early for the sequester to rescind them. So the sequester will apply mostly to funds they would use in 2014. That buys school districts extra time to plan for those cuts, or Congress additional time to cancel the cuts before they happen.

Still, some school districts will be harder hit than others because they receive a larger portion of their budgets from federal monies. Some of those districts receive most of their funding from the federal Impact Aid program, which helps districts that lose out on property taxes because of federally advantaged property or personnel within their borders (like military bases or Native American reservations).

The Impact Aid program, funded in fiscal year 2012 at $1.153 billion, will drop to about $1.065 billion post-sequester. At about 75 of the school districts, the cuts to Impact Aid will be more than $500 per pupil. A dozen school districts will receive at least $1 million less in Impact Aid than under the 2013 continuing resolution – and that leaves aside other federal dollars those districts receive, like Title I and special education money.

And the schools seeing these significant, mid-year cuts are among the neediest schools in the nation. Nearly 350 Impact Aid districts have a reported poverty rate of at least 30 percent, according to the Census Bureau. In 2010, 87 percent of the schools had at least 30 percent of their students enrolled in the free- and reduced-price lunch program, a proxy for measuring the concentration of low-income students. More than sixty percent of districts had over half of their students in the program.

The most severely affected school districts, though, are likely to be the twenty percent that received more than a quarter of their revenue from the federal government in 2009.  Eighty-six of those school districts were funded more than half by federal dollars.

The costs of an 8.2 percent cut to every federal program are far more concentrated in schools with significant amounts of federal money at stake. Meanwhile, those schools are some of the most vulnerable in the nation. We anticipate the “fiscal cliff” agreement between Congress and the President will include more spending cuts – but we hope they are targeted to protect the students who most need the extra boost. 

Click here to download these data for every Impact Aid recipient in the country. To view other federal funding, demographic, and achievement data for every school district in the U.S., visit the Federal Education Budget Project’s database.

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.