Yesterday, the Center for American Progress (CAP) released a paper arguing that Congress should reduce the interest rate on outstanding federal student loans, a concept it refers to as “refinancing.” Congress sets the rate on federal student loans – somewhat arbitrarily – at a fixed 6.8 percent, and CAP is calling on lawmakers to re-set it lower for existing loans.
Leaving aside CAP’s rationale for the policy, which is critiqued in an earlier post, it is worth pondering why CAP goes to so much trouble to describe how the refinancing program would work. The paper walks through byzantine financing trusts the Department of Education set up to make student loans during the financial crisis; an emergency lending program run by the Federal Reserve; federally-backed funds; and a loan consolidation program that could be used to provide borrowers with lower interest rates. Why all this complexity?
CAP could instead simply propose that the federal government cut a check to everyone with a federal student loan in some proportion to the amount owed and the interest rate on the loan. This would be far simpler than CAP’s complex suggestions, and it would have exactly the same outcome for both the borrower and the government. Borrowers would have more disposable income, and the government would be out by the same amount.
But the unnecessary financial transactions make it appear as if there is some logical connection between refinancing student loans and refinancing and low interest rates on other types of debt in the private market. All day, every day, borrowers and lenders in the private debt markets, and private buyers and sellers, respond to market forces that drive interest rates lower on everything from auto loans and home mortgages to corporate bonds.
But there is no such refinancing market for federal student loans because borrowers already have a better rate than the market will offer. The only way to lower what borrowers pay on those loans is for Congress to cut the rate even further below the market rate.
Given that the government holds the loan (or backs it) and sets all of the terms on it, cutting the interest rate is effectively the same as sending checks to borrowers. Yet knowing that Congress is a sucker for a Rube Goldberg machine, CAP hopes that by calling it “refinancing” and erecting complicated legislative and financial machinery to execute the plan, observers will mistake it for a market transaction. Lest you think this is an unfair characterization, here’s how the authors put it:
One benefit of a federally backed student loan refinancing and modification program… is that it is relatively simple to grasp—many Americans are familiar with similar mortgage-refinancing programs.
CAP, here is a way to make the proposal even simpler to understand: Design it to issue government checks directly to people with student loans. That will leave no doubt as to what the program does or how it works.
If the program still sounds like a good idea in those terms, remember that the rates on federal student loans are already below market and carry benefits that no lender can beat, with protections galore for struggling borrowers – including deferment, 3-year forbearance, interest-only payments, extended terms, and income-based repayment with loan forgiveness. Refinancing is simply a different way to describe the government sweetening the deal just a little bit more. Some borrowers are indeed struggling to repay their loans, but too often underutilize the benefits Congress and the Department of Education have already provided. That is where more work is needed.