The Center for American Progress yesterday issued a preview of its upcoming proposal, which argues that Congress should allow people to refinance their student loans. The authors point out that the interest rate on the most widely-available federal student loan is a fixed 6.8 percent, but interest rates on other types of debt, like home mortgages and U.S. Treasury securities, are lower. Thus, they argue, borrowers with federal student loans should be able to take advantage of the lower rates. This line of reasoning is alluring, but it belies some key facts about federal student loans and lending markets in general.
First, no one with a federal student loan is barred from seeking out better terms elsewhere and refinancing their debt. In fact, the loans work exactly like home mortgages when it comes to refinancing. Borrowers are free to shop around for the best terms that a lender is willing to offer and use the proceeds from a new loan with better terms to pay off the old loan. Moreover, federal student loans never charge a “prepayment penalty” under which the borrower would be assessed a fee for paying off the loan early in a refinancing, or for any other reason.
Some might claim it is irrelevant that student loans and home mortgages can be refinanced in exactly the same way. After all, lots of lenders compete to refinance home mortgages, driving down interest rates in the market, but no such market exists for student loans. The lack of such a market, however, demonstrates a key point: The terms on federal student loans are still better than what private lenders offer. CAP’s proposal even notes that rates on private loans are twice as high as those on federal student loans. In other words, when it comes to federal student loans, borrowers already have the best terms available in the private market, and then some. What CAP and others must mean when they call for lower rates on student loans is that borrowers don’t have the best terms that the federal government can offer.
But that is a tricky argument to make. How does one measure what the government’s best terms ought to be? What should policymakers use as benchmarks, given that the terms on student loans are already the best available anywhere?
Like many observers, the Center for American Progress points to the interest rates on the government’s debt. Those rates are low and student loan rates are higher, the authors argue; therefore, borrowers should be able to refinance. That is an appealingly simple argument, but a deeply flawed one.
Yes, banks make money when they borrow at a low rate and lend at a higher rate, but there is another essential component to that equation. Finance 101 teaches that it is theoretically impossible for anyone to borrow at a low rate and lend at a higher one unless someone also kicks in extra money to take the first loss. That extra money, the equity, acts like a buffer between the people from whom the bank is borrowing and the people to whom it is lending – and it is why the bank can borrow at a lower rate than it charges to lend the money out in the first place.
Most people are familiar with the concept of equity that takes the first loss, but may not realize it. When a bank issues a home mortgage, it requires the buyer to make a 20 percent down payment, which is equity. If home prices fall, the first 20 percent decline will be borne by the homeowner, not the bank. Similarly, when a bank borrows from someone at a low rate and relends that money out at a higher rate, the person who lent to the banks wants a similar buffer between his money and the loan the bank is making. It increases the chances he will be paid back.
Equity, however, is obviously not free. That is why banks, who can borrow from depositors at rates as low as the federal government (the deposits are guaranteed by the federal government, after all) do not offer loans at terms that beat those on federal student loans – especially when taking the non-interest rate benefits on federal student loans into account, such as universal eligibility, no credit or income checks, no co-signer requirements, income-based repayment with loan forgiveness, 30-year repayment plans, three-year forbearance plans, and unlimited in-school deferments. Despite being able to borrow at low rates, a bank lending at those terms would send its equity investors fleeing.
When the federal government makes student loans, it is the taxpayers who act as equity holders. They are on the hook for any loss, since U.S. Treasury bondholders will always be paid back (debt ceiling debate notwithstanding). Therefore, arguing that interest rates on federal student loans should bear more resemblance to the low rates on U.S. Treasury notes implies that the federal government (i.e., the taxpayer) has no equity at risk in the transaction, or that the taxpayer is a source of free equity for the federal government. Neither is true.
The government’s cost to borrow is therefore an incomplete benchmark for calculating what the “break-even” interest rate on a federal student loan would be and determining whether rates are set too high. In other words, what investors demand when they lend to the federal government for 10 years is not what they would charge to lend to a student for 10 years. Even the most inexperienced investor knows that lending to the government is less risky than lending to a student.
Proposals for a federal student loan refinancing program boil down to this. Even though the federal government makes student loans at below-market rates and terms that no lender can beat, with protections galore for struggling borrowers, it could always sweeten the deal just a little bit more. But why should it? What is the goal, other than to slowly transfer money to people who meet no other metric of need other than the number in front of the percent sign on their student loan statement? There are indeed borrowers struggling to repay their loans, but ensuring that those borrowers are aware of and can easily enroll in repayment benefits that already exists seems like a much more targeted and far less costly way to deliver assistance.