Looking for our new site?

Ed Money Watch

A Blog from New America's Federal Education Budget Project

< Back to the Education Policy Program

No-Cost Solution to Student Loan Interest Rates Hidden in Plain Sight

Published:  May 8, 2012

Update: For the most recent post on this topic, check out "Proposed 3.4 Percent Interest Rate Not the Best Deal for Students or Taxpayers."

Congress is now officially deadlocked over how to pay for a one-year extension of the 3.4 percent interest rate offered on newly-issued Subsidized Stafford student loans. The disagreement isn’t over extending the rate, but where to find the extra $6 billion needed to pay for it. In the midst of all the partisan bickering, wouldn’t it be great if Congress could magically lower interest rates for all borrowers without cutting other programs or raising taxes, while reducing budget deficits in the meantime? Take a look at the Congressional Budget Office’s “Reducing the Deficit: Spending and Revenue Options” publication from March 2011 (page 32).

The CBO has provided a cost estimate for a proposal that would link the interest rate on all newly-issued federal student loans—Subsidized and Unsubsidized Stafford, Graduate and Parent PLUS—to long-term U.S. Treasury borrowing rates.  (The CBO isn’t endorsing the proposal, just showing lawmakers how it would ‘score’.) Interest rates would still be fixed for the life of the loan, but the rate would change each year loans are offered based on market rates for Treasury notes. The proposal sets the rate for newly issued loans based on the interest rate on 10-year Treasury notes at the time the loan is issued, and adds a premium of 3 percentage points to it.

That formula would make the rate on loans issued this fall fixed at 4.9 percent, a big drop from the current 6.8 percent rates. What’s more, that rate would be available to all undergraduate and graduate borrowers, unlike the proposal pending in Congress to provide lower rates for only some undergraduates. Of course, next year the rate could be higher or lower depending on what happens to interest rates in the market. The CBO assumes it will be higher. That’s where the deficit reduction (i.e. cost savings) comes in.

If and when the interest rates on 10-year U.S. Treasury notes rise, the fixed interest rate on newly-issued student loans will also increase. Once rates on those securities rise above 3.8 percent – the rates are currently 1.9 percent – the interest rate on newly issued student loans will exceed 6.8 percent, the current fixed interest rate. Because CBO assumed that interest rates will rise in the future, it assumed that borrowers will pay higher rates in the future than under current law, reducing spending and the deficit. According to the estimate, this new rate structure would reduce the deficit by $52 billion over ten years.

Keep in mind that CBO calculated this estimate in early 2011 when long-term interest rates were higher. That means the savings that would be ‘scored’ under the same proposal today are likely less. At the same time, the proposal CBO used for its estimate would charge the same interest rate on PLUS loans to graduates and parents of undergraduates as the rates on Stafford loans, a break from historical policy. If lawmakers opted to charge a higher interest rate for PLUS loans like they do currently, the total savings would be more in line with CBO’s 2011 estimate. 

Some student aid advocates and policymakers will likely dismiss this proposal because it could mean that future borrowers take out loans at rates higher than 6.8 percent. Still, that seems like a better policy than what we have today – fixed 6.8 percent rates on loans issued every year no matter what happens in the market. Furthermore, it will make rates on newly-issued loans more closely resemble the interest rates private lenders charge on home mortgages, something many student aid advocates seem to want.

The market-based, fixed-rate proposal like the one CBO scored in its 2011 publication is also better than a variable rate structure where rates are reset on all outstanding loans once a year. Too many advocates and policymakers seem to be falling for the allure of low variable rates as a way out of the current interest rate debates. But variable rates are a shortsighted solution. In fact, the drawbacks of variable rates – uncertainty and the risk that rates remain higher for years – are why Congress adopted fixed rates in the first place.

The lesson here is that fixed rates are an important benefit for borrowers as they provide a measure of certainty – but the rates on newly-issued loans do need to adjust when interest rates in the market change. The proposal outlined in a 2011 CBO cost estimate shows that Congress can adopt exactly that policy and save money at the same time.

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.