Countless journalists, advocates, and lobbyists claim that the government profits when students default on their federal loans. But this week’s release of President Obama’s fiscal year 2013 budget brings further evidence that nothing could be further from the truth. The budget includes a new section that explains more fully the estimated recovery rates on defaulted federal student loans. The recovery rate refers to the percentage of defaulted loan volume the government expects to eventually collect.
This newly-released information also contradicts those who argue that the government doesn’t bear any default risk in making student loans. That’s exactly the argument that a number of readers have made criticizing a recent Federal Education Budget Project (Ed Money Watch’s parent initiative) issue brief that concludes that the current fixed 6.8 percent interest rate on federal student loans isn’t a money-maker for the government, due in part to the cost of loan defaults.
Take a look at the student loan section of the FY 2013 Department of Education Justifications of Appropriation Estimates to the Congress. On the last two pages of the student loan section of that document is a detailed explanation of what share of loans are expected to default and how much the government will ultimately be repaid. A helpful table shows that the U.S. Department of Education expects 23 percent of Subsidized Stafford loan volume issued in fiscal year 2013 to go into default at some point.
After the federal government pays collection agencies to recover the loan, the government is likely to recover about 96 percent of what the borrower owes. But those efforts could take decades, and time is money. Once the risk-free time value of money is factored in, the recovery rate drops to 82 percent. It’s even lower for Unsubsidized Stafford loans (78 percent) and PLUS loans (76 percent) which together will account for three-quarters of the loan volume issued in 2013.
In fact, these estimates are actually on the high side because the U.S. Department of Education calculates the time value of money at risk-free interest rates. A risk-adjusted rate would better reflect the fact that the estimated collections are not guaranteed to happen as projected (i.e. they are not risk-free). By that measure, recovery rates are likely to be even lower than those shown in the president’s budget.
A National Bureau of Economic Research study that uses risk-adjusted rates finds that recovery rates are only about 50 percent, which the study finds is in line with the experiences of private student loan providers. (Like federal student loans, private student loans are not dischargeable in bankruptcy, so they tend to have higher recovery rates than other types of consumer debt.)
All in all, the more complete recovery rate information on student loan defaults that debuted in the president’s budget should help set the record straight. Student loan defaults are costly for borrowers and taxpayers alike. And for those who still believe federal student loan interest rates are too high because the loans pose no default risk for taxpayers and that the federal government is the world’s best debt collector: In the words of the U.S. Department of Education, “some loans may have little or no recoveries while others may have substantial collections” [emphasis added].