Two weeks ago Ed Money Watch explained an alternative to the one-year extension of the 3.4 percent interest rate on newly-issued Subsidized Stafford loans for undergraduates pending in Congress. It would peg fixed rates on all new federal student loans to the 10-year Treasury rate plus 3.0 percentage points in the year the loans are issued. While the Congressional Budget Office says that extending the 3.4 percent interest rate on Subsidized Stafford loans by one year will cost $6 billion, this alternative proposal cuts spending by $52 billion. How have lawmakers and student aid advocates responded to this proposal? With deafening silence.
Policymakers and advocates think this proposal isn’t politically viable or beneficial for borrowers because it would set fixed rates on Subsidized Stafford loans issued this year at 4.75 percent for the upcoming school year (based on the May 21, 2012 rate), which is higher than the current 3.4 percent that may be renewed. If any proposal sets the rate higher, some borrowers will pay more, they say. (The 10-year Treasury note proposal lowers rates for graduate students, too, but we will leave that aside for purposes of the discussion that follows.)
These skeptics obviously haven’t done the math. Nearly all undergraduates who borrow this year would owe less at graduation and pay less monthly under the proposed alternative—even those who are eligible for Subsidized Stafford loans at the 3.4 percent rate under the pending extension.
The table below compares how undergraduates who borrow the maximum amount of Subsidized and Unsubsidized Stafford loans in each year will fare under both interest rate proposals.
Here are a few key points on how the figures were calculated:
Regardless of financial need, all first-year, dependent undergraduates automatically qualify for $5,500 in Unsubsidized Stafford loans at a fixed interest rate of 6.8 percent. Within that limit, however, a borrower may qualify for up to a $3,500 Subsidized Stafford loan (which would carry the 3.4 percent interest rate) if he meets a needs analysis test. If a borrower qualifies for that maximum, then he has two loans: one loan of $3,500 at the 3.4 percent rate and another of $2,000 at the 6.8 percent rate within the $5,500 limit. The breakdown is a bit different for each year a borrower is enrolled, and many borrowers qualify for less than the $3,500 in Subsidized Stafford loans because eligibility is based on a sliding scale.
Additionally, under current law, Unsubsidized Stafford loans accrue interest annually while a borrower is in school. No interest accrues on Subsidized Stafford loans during that time. As a result, a student’s loan balance at graduation is not just the sum of their Subsidized and Unsubsidized Stafford loans, but the sum of their loans plus accrued interest. Thus, we calculate the weighted average interest rate for each year a student borrows based on the share of the student’s total loan balance at graduation that is Subsidized (3.4 percent interest) and Unsubsidized (6.8 percent interest).
In contrast, the 10-year Treasury note proposal Ed Money Watch discussed earlier would set the same fixed interest rate for both loan types. As a result, no weighted average annual interest rate applies.
Due to the higher interest rate on Unsubsidized Stafford loans under the pending one-year extension of the 3.4 percent interest rate for Subsidized Stafford loans, a borrower will actually graduate with a higher loan balance under the 3.4 percent rate proposal than under the 10-year Treasury note proposal. In fact, the higher rate of interest accrual skews the weighted average interest rate under the 3.4 percent rate proposal above 4.75 percent for first year students.
And even though second, third, and fourth year students will pay lower average interest rates on the loans they take out in each year under the 3.4 percent rate proposal, the higher interest rate on the Unsubsidized portion of their loans will result in higher loan balances. In the end, a student that borrows the maximum amount in all four years will actually pay less per month under the 10-year Treasury note proposal than under the 3.4 percent rate proposal.
To be fair, a very small share of students could end up paying a tiny bit more under the 10-year Treasury note proposal (a few dollars a month) for loans they take out this coming school year compared to the 3.4 percent interest rate proposal (e.g. students who borrow Subsidized Stafford loans but forgo the extra Unsubsidized Stafford loans for which they qualify). But many more borrowers—including graduate students—will benefit from the lower rate under the 10-year Treasury note proposal. Some critics will also point out that interest rates on future loans could be higher than 4.75 percent, even higher than 6.8 percent. That is true, but if the concern is that rates might go higher, then borrowers and policymakers may be better off just sticking with the current 6.8 percent.
Finally, some would-be supporters are nervous that President Obama and Democrats in Congress will accuse anyone who supports the 10-year Treasury note proposal instead of the 3.4 percent rate proposal of “raising interest rates on student loans.” If they do, point to this analysis. If they dismiss this analysis, then they are more interested in scoring political points than helping students.