Looking for our new site?

Ed Money Watch

A Blog from New America's Federal Education Budget Project

< Back to the Education Policy Program

Capped Variable Interest Rate Proposal Comes with a Hefty Price Tag

Published:  May 10, 2012

While Congress has debated extending the 3.4 percent interest rate on Subsidized Stafford loans issued this year to undergraduates, advocacy groups are gearing up for a debate on longer-term reforms. They know the odds don’t favor Congress adopting a one-year extension of the lower rate again next year. Besides, spending $6 billion to save college graduates $9 a month isn’t a great deal for borrowers or taxpayers. So it’s good that student aid advocates want a better plan. But they aren’t off to a great start. They are gathering support for an outrageously expensive proposal that turns a blind eye to far more worthy aid, like Pell Grants.

The student loan interest rate proposal that is dominating discussions among advocates and other stakeholders would provide borrowers with variable interest rates that would be capped at the current fixed rates of 6.8 percent on Stafford loans and 7.9 percent on PLUS loans for parents and graduate students.

The rate on all newly-issued federal loans would be adjusted annually based on interest rates on short-term (three month) U.S. Treasury debt, plus a markup of two to three percentage points to partially offset costs. Today, that would translate into an interest rate of about 3 percent. If short-term U.S. Treasury rates rise, the rate borrowers pay would too, though it would never exceed 6.8 percent. Such a proposal would represent a return to the policy of the 1990s and early 2000s, except the cap on the variable rate then was 8.25 percent.

This variable-rate-with-a-cap proposal would give borrowers a “heads-I-win, tails-you-lose” arrangement. If short-term rates stay low, borrowers benefit. If short-term rates rise, the loans convert to low, fixed rates and the borrower wins again. When short-term rates decline, the fixed-rate loan converts back to a variable rate, and the borrower wins again.

The policy effectively shelters borrowers from the financial tradeoffs that they would normally face when they choose between fixed and variable interest rates on loans in the private market. Variable rates are lower at first, but can go higher. Fixed rates might be higher on average, but they provide certainty.

The variable-rate-with-a-cap proposal doesn’t, however, make that fundamental tradeoff disappear. It just shifts the cost entirely onto taxpayers.

How much would taxpayers have to pay to provide borrowers with this no-lose insurance policy? According to sources on Capitol Hill, the Congressional Budget Office says it would cost $200 billion over 10 years.

To put this price tag in perspective, Congress could fund an $8,000 maximum Pell Grant (up from $5,550 today) for the next 10 years if it allocated an additional $200 billion to the program over that time period.

Still, there are other options for policymakers to modify student loan interest rates that would make meaningful improvements for borrowers without breaking the bank. One even generates savings (read more here).

Students and aid advocates would be wise to rally around some version of a more feasible interest rate reform proposal in the coming months. But if they really want to get behind a proposal that costs $200 billion, please make it one that supports the Pell Grant program rather than college graduates’ monthly budgets.

Join the Conversation

Please log in below through Disqus, Twitter or Facebook to participate in the conversation. Your email address, which is required for a Disqus account, will not be publicly displayed. If you sign in with Twitter or Facebook, you have the option of publishing your comments in those streams as well.