Ed Money Watch

Last week Senators Coburn (R-OK) and Burr (R-NC) introduced a bill that would replace the arbitrary interest rates on newly-issued federal student loans with rates linked to 10-year U.S. Treasury notes, plus 3.0 percentage points. We explained in an earlier post how the proposed policy would make interest rates on student loans more responsive to changes in the market and allows student loans to reflect today’s low interest rate environment.  Fixed rates on all loans issued this coming school year would be about 4.75 percent. What’s more, the proposal is budget neutral in the long run, even under the Congressional Budget Office’s most recent estimate—but there is a catch.

Back in 2011 the Congressional Budget Office estimated that the proposal would reduce the cost of the federal student loan program over the next five and ten years by $0.9 billion and $52 billion, respectively. The CBO has now updated its original estimate (based on its 2012 forecast for long-term interest rates) and finds that the proposal reduces the cost of the loan program by $6 billion over ten years, but—and here’s the catch—in the short run, costs would go up by $29 billion.

Under both estimates, the long-term savings arise because CBO believes that the proposal will lead to student loan interest rates that are higher on average over the next ten years than rates under current law, even though the proposal would provide big rate cuts in the most immediate years. In other words, the proposal lowers costs by charging borrowers more on average, but not until rates rise in the future.

This effect is apparent in the table below comparing the two cost estimates. In the first few years, costs increase, but in later years, the proposal produces savings. On net, both estimates show a spending reduction over ten years.

Why did this year’s cost estimate change so much relative to last year’s?

Briefly, it’s because long-term interest rates are much lower now than they were just a year ago, and the CBO now believes they will stay that way over a longer period. In the short run, the proposal to link student loan interest rates to 10-year Treasury notes would lower interest rates on newly-issued loans more than the CBO first projected. That’s because in the near term, the CBO now expects rates to be dramatically lower than it did when calculating its 2011 estimate. Over the long term, though, the proposal wouldn’t raise them as much as first projected.  So the total savings over ten years drops from $52 billion to just $6 billion. That’s why the proposal would come at a cost of $29 billion in the first five years now, compared to a savings of $0.9 billion under the prior estimate.

If Congress wants to get the savings back in line with the original estimate, they could make a simple and sensible modification to the proposal: add a premium to the interest rates on PLUS loans for parents and graduate students.

Graduate students and parents of undergraduate students can borrow up to the full cost of attendance through the federal PLUS loan program. The program is meant to provide additional loan limits for borrowers who exhaust the Stafford loan limits. Historically, PLUS loans have charged a higher interest rate than Stafford loans. That premium is currently 1.1 percentage points, so the rate on PLUS loan is 7.9 percent compared to the Stafford loan rate of 6.8 percent.

The Coburn-Burr proposal and the proposal for which the CBO has provided cost estimates do not include a premium for PLUS loans. Instead, the rates would be the same on both PLUS and Stafford loans. If the proposal did charge a premium, such that the PLUS loan interest rate would be equal to the rate on the 10-year Treasury note plus 4.1 percentage points (instead of 3.0 percentage points), it would lead to lower upfront costs and more long-term savings because PLUS loan borrowers would be charged higher rates.

With that sensible fix, linking the interest rates on all newly-issued federal student loans still looks like a far better proposal than the arbitrary rates in place or the pending one-year extension of the 3.4 percent interest rate on Subsidized Stafford loans for undergraduates.