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Ed Money Watch

A Blog from New America's Federal Education Budget Project

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How Income-Based Repayment Can Cap, Reduce, or Eliminate Interest Rates on Student Loans

Published:  April 15, 2013

The president’s fiscal year 2014 budget request includes a proposal for setting interest rates on newly issued federal student loans. Rates would be fixed for the life of the loan and set at a rate equal to the interest rate on 10-year Treasury notes, plus 2.93 percent for Unsubsidized Stafford loans, the most widely available federal student loan. (Subsidized Stafford loans would be set at the 10-year Treasury rate plus 0.93 percent, and PLUS loans for parents of undergraduates and for graduate students set at 10-year Treasury plus 3.93 percent.)  The rate would not be subject to a nominal cap. The approach is similar to one highlighted a year ago on this blog and again this year in the New America Foundation paper Rebalancing Resources and Incentives in Federal Student Aid.

The fact that the president excluded a cap in his proposal (as did the New America Foundation) has rankled student aid advocates (see here, here, and here). We’ve argued that the new income-based repayment (IBR) program that became available last year for students who began borrowing after October 1, 2007 ensures that a borrower’s monthly loan payments are capped – which therefore makes it a more generous benefit than an interest rate cap. Further, the program’s 10-year and 20-year loan forgiveness terms reduce, cap, or eliminate the interest that a borrower must actually pay, depending on the situation.

How does it do that? A borrower’s payments under IBR are based on his income, and the total time he is required to repay is limited through loan forgiveness, so there is a limit to how much he can ever pay on his loans -- and that limit can make the nominal interest rate on the loan or the amount borrowed irrelevant.

In a recent blog post, the Institute for College Access and Success (TICAS) offers an example in which a borrower pays more in total lifetime payments when the interest rate on the loan is higher. Is that inconsistent with the above statement? Not at all.

The borrower in the TICAS example has $20,000 in debt, has an Adjusted Gross Income of $30,000, and presumed household size of 1 (i.e. not married/married filing separately and no children claimed as dependents). Therefore, we can plot the interest rate cap that IBR would provide on her loans at various debt levels and based on whether she will have her debt forgiven after 10 or 20 years.

IBR Interest Rate Cap 2.png

The Income-Based Repayment plan reduces and ultimately caps the borrower’s interest rate at 12.8 percent. After that point, any unpaid interest or principal balance on the loan will be forgiven due to the maximum term of 20 years under IBR. And if the borrower had $30,000 in debt, IBR caps the interest rate at a very low 3.6 percent. At $50,000 in debt, her interest rate is capped at 0.0 percent – given her income she won’t pay even as much as her initial loan balance, so her interest rate is irrelevant. Why the big differences in interest rate caps? Again, her total payments on her loan have a limit based on her income and the 20-year term of the loan -- so more debt must translate into a lower interest rate cap and lower debt results in a higher interest rate cap.

Now suppose the borrower with $20,000 in debt in the TICAS example works for a non-profit, thereby qualifying for public service loan forgiveness after 10 years of payments. With PSLF, IBR caps her interest rate at 0.9 percent. At $25,000 in debt the interest rate is effectively capped at 0.0 percent. These figures are so much lower than under the 20-year forgiveness becuase the total payments this borrower could ever make are much lower, all because the loan term cannot exceed 10 years.

And if the borrower has a child to declare in her household size, all of the numbers cited above are lower because the program increases the allowable income exemption for each dependent child in calculating the monthly payment. But rather than write out more examples, the table above is instructive. The information in the table is for a borrower who matches the income profile of the borrower in the TICAS example. We use the New America Foundation IBR calculator for all calculations. 

As the table above demonstrates, IBR provides very valuable benefits by reducing, capping or eliminating interest rates on federal loans. (However, the perverse incentives to borrow more and the windfall benefits for high-income high-debt borrowers, mainly graduate students should be addressed.) No doubt, a nominal interest rate cap written into law can provide even greater benefits for borrowers in certain circumstances. But is a cap necessary given the benefits of IBR and would it be worth the extra costs? Probably not, and the Obama Administration agrees.

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