Common Ground Project: Direct Federal Student Loans Citizens for Political Reform

Common Ground Project: Direct Federal Student Loans Citizens for Political Reform THE ISSUE We are fast approaching June 30 the date on which the current 3.4% interest rate for subsidized Stafford loans is once again set to expire. If Congress does not act, this rate will double to 6.8% for new loans, affecting millions of student borrowers. Numerous proposals are currently being considered regarding how to approach the impending expiration date. Substantive, yet bridgeable differences exist between Democrats and Republicans. THE BACKGROUND Question: What is a direct federal student loan? Answer: Direct federal student loans are funds borrowed directly from the federal government to help students and their parents pay for higher education. These loans have low interest rates and offer flexible repayment terms, benefits, and options. i Today there are over $553 billion in outstanding direct student loans. ii In 2013, 21.5 million direct loans will be made at an average of about $5,000 per loan. Question: What types of direct federal student loans are available? Answer: There are four basic direct federal student loan plans that are outlined below with each having its own loan details and annual award limits. Colleges and Universities also administer Federal Perkins loans, which are need-based subsidized loans awarded to undergraduate and graduate students. iii If Congress fails to act, and the current rate for new subsidized Stafford loans expires, Perkins loans will not be affected. 1. Subsidized Stafford Loans are available only to undergraduate students who demonstrate financial need, and who are enrolled at least half-time at a university. Awards are between $3,500 and $5,500 depending on a students year in school. For loans made between July 1, 2011 and June 30, 2013, the interest rate is fixed at 3.4%, however students are not charged interest while they are in school or during deferment periods. iv

2. Unsubsidized Stafford Loans are available only to undergraduate students and graduate students who are enrolled at least half-time at a university. Awards are between $5,500 and $20,500, depending on the students year in school and dependency status (the higher borrowing limits are for graduate students). Interest accrues on the loan while the student is in school and the student is responsible for repaying the loan with a fixed 6.8% interest rate. 3. PLUS Loans for Parents are available to parents of dependent students who are enrolled at least half-time at a university. Parents may borrow up to the cost of attendance minus any other financial aid the student receives. The average Parent PLUS loan was $12,575 in academic year 2011-12. v The PLUS loan is made without regard to the parent s ability to repay, although parent may not receive a loan if they have another account that is in collection or they have defaulted on another debt. The parent is responsible for repaying the loan with a fixed 7.9% interest rate. The Parent PLUS loan is not eligible for many of the benefits of other student loans, such as income-based repayment. 4. PLUS Loans for Graduate or Professional Students are supplemental loans to graduate or professional students, in addition to the Stafford unsubsidized loans. Graduate and professional students may borrow up to the maximum cost of attendance minus any other financial aid the student receives, including Stafford loans. These loans are given to graduate or professional students enrolled at least half-time. The average Graduate PLUS loans in academic year 2011-12 were $19,958. The student is responsible for repaying the loan with a fixed 7.9% interest rate. The interest accrues on the loan while the borrower is in school. Question: How many students receive direct federal student loans? Answer: In 2011-2012, 10.4 million students took out federal student loans. Of these, 1.6 million graduate students took out Stafford Loans, and 360,000 borrowed under the PLUS loan program. Of the graduate students who took out Stafford loans, 79% took out both subsidized and unsubsidized loans, 15% took out only subsidized loans, and 6% took out only unsubsidized loans. vi Subsidized Stafford loans are no longer made to graduate and professional students. During the same period, 8.8 million undergraduates took out Stafford loans, while 879,000 parents borrowed under the PLUS loan program. Of the undergraduate students who took out Stafford loans, 73% took out both subsidized and unsubsidized loans, 16%

took out only subsidized loans, and 11% took out only unsubsidized loans. vii It is important to note that all direct federal loans made to students, subsidized or unsubsidized, are eligible for income-based repayment (explained below). Question: What is the impact on the federal budget from making and supporting direct federal student loans? Answer: The Congressional Budget Office (CBO) estimates that the federal student loan program reduces the deficit by about $51 billion for FY2013. This is an unusually large amount that is driven by today s low government borrowing costs, federal credit scoring procedures, and a scheduled doubling of the interest rate paid by new subsidized Stafford student loan borrowers (that Congress may act to void). CBO estimates that, under current law, in FY2023 the student loan program will contribute about $6 billion to deficit reduction. However, these estimates are subject to controversy. CBO has issued several reports indicating that the current budget scoring may understate the cost (or overstate the benefit) of the student loan program to the federal government. CBO s estimates assume that the increase in the interest rate of subsidized Stafford loans set to happen this month will go into effect. If Congress were to make the current 3.4% rate permanent, that would significantly increase the cost of the program and reduce the current estimates of the benefit. There are other proposals that would set student loan interest rates based on the cost of federal borrowing at the time of origination; depending on the specific proposal some would increase budget costs in the near term while others would have a more stable budgetary impact. viii Under federal budget scoring rules, the cost of student loans is discounted based on the government s borrowing cost only. Many argue, including CBO, that estimates of the cost of the loan program should also be discounted by some measure of risk, which would reflect the likelihood that repayments will be lower than expected. As such, the true cost of the student loan program to taxpayers is likely higher than federal budget estimates indicate.

Question: Interest rates on direct federal student loans are set to double after the current rates expire on June 30, 2013. How much will rates increase? Will this scheduled increase apply to all types of direct federal student loans? What will the effect be on borrower s payments? Answer: It is true that certain rates are set to double for loans originating beginning on July 1, 2013. However, only the interest rate for new subsidized Stafford loans, currently fixed at 3.4%, will double to 6.8%. All other loan programs will be unaffected if Congress does not act. However, certain proposals currently being considered in Congress may affect interest rates for other categories of student loans. It is important to emphasize that interest rates for outstanding loans will not change on July 1. The scheduled increase to 6.8% will affect about 7.9 million borrowers who take out new Stafford subsidized loans. The maximum amount that a student may borrow under this program is $5,500. Stafford subsidized borrowers do not pay interest while they are in school. When they enter repayment, the 3.4% increase in rate would translate into an increase monthly payment of approximately $10 a month. Question: How many students would be affected by an increase in the interest rate for subsidized Stafford loans? Answer: While Congressional inaction will only lead to increases in new subsidized Stafford Loan interest rates, this increase will still affect millions of students. In 2011-2102, 7.9 million undergraduate students took out some amount of subsidized Stafford loans. ix Question: How do interest rates for direct federal student loans compare to interest rates for private student loans? Answer: Interest rates for direct federal student loans are fixed rate loans, while most private education loans are variable rate loans with the interest rate established by the credit worthiness of the borrower or, most often, the co-signer. Federal student loans are made without any regard to the student s ability to repay, based on the assumption that the education itself will increase the earning capabilities of the borrower. As such, the fixed rates of 6.8% and 7.9% on loans that are likely to repay over 10 or more years are significantly lower than other forms of unsecured consumer credit. The current interest rate environment has benefited borrowers with variable rate loans; the CFPB found that the average rate on private student loans originated in 2005 was less than 6%. Yet, the rates on these loans can rise if and when interest rates increase. x

Question: How does offering student loans impact the economy? Answer: Student loans enable substantial economic benefits for individuals and society, but there are negative effects. By facilitating access to higher education, the availability of federal student loans may lead to higher productivity and income levels and therefore may contribute to increased economic growth. But, there is evidence that high levels of indebtedness from student loans has, in some cases, contributed to later household formation, delays of major purchases, such as homeownership, and reduced small business formation among young adults. xi Additionally, there is concern that artificially low interest rate loans may be driving up the costs of higher education and are part of the reasons colleges continue to increase tuition. xii Question: What is Income Based Repayment? Answer: The standard repayment plan for federal student loans is a fixed, monthly payment for up to ten years. Graduates with modest incomes may elect income based repayment (IBR), available since 2009, which caps the monthly payment amount based on income and family size, but may extend the life of the loan, resulting in a higher overall interest cost to the borrower. In most cases, the maximum payment under IBR is 15 percent of income; the cap will be 10 percent for all loans originated beginning in July 2014. Income-based repayment offers another significant benefit. Outstanding federal student loan debt is forgiven after 25 years of payments for most borrowers; graduates who enter public service careers can have any remaining balance on direct loans forgiven after 10 years of payments. The IBR option is available for all federal education loans taken out by a student, including for graduate and professional school, whether subsidized or unsubsidized. It is not available for PLUS loans made to parents of a student. xiii THE HISTORY In 2007, a newly elected Democratic controlled Congress passed the College Cost Reduction and Access Act and set a schedule for reducing interest rates on new subsidized Stafford loans for undergraduates each academic year thereafter until reaching 3.4% in 2011. Last year, the 3.4% interest rate was set to expire, and return to the 6.8% rate that was in effect before the passage of the College Cost Reduction and Access Act. xiv Congress agreed to extend the 3.4% rate for one year an extension with an expiration date of

June 30, 2013. The extension cost $6 billion over the next 10 years and was offset by changing the way corporate pensions are calculated and by increasing premiums paid to the Pension Benefit Guaranty Corporation. THE STATE OF THE LEGISLATIVE DEBATE Both House Republicans and President Obama have put forth plans to link student loan rates to the cost of borrowing. However, they each take slightly different approaches. 1. The House recently passed a bill that would tie direct federal student loan interest rates to 10-year Treasury bills plus an additional 2.5% for all Stafford loans and an additional 4.5% for PLUS loans. Interest rates would not be fixed, but would be recalculated yearly based on fluctuations in the economy, similar to the rates on all student loans between 1992 and 2006. Stafford loan interest rates would be capped at 8.5% and PLUS rates would be capped at 10.5%. Republicans argue this bill would give students and parents additional certainty, reversing the current trend of setting rates based on the mood and present impulse of Congress. xv The House Republican plan will reduce the deficit by $1.0 billion over the next five years and $3.7 billion over the next ten years, according to the CBO. xvi But, the President issued a veto threat, citing a CBO report which reveals that by 2023, the interest rate on all Stafford loans would climb to 7.7% under the GOP plan. 2. Likewise, President Obama s plan also ties interest rates to 10-year Treasury bills. However, Obama would fix rates for the entire life of the loan, and add 0.93% to the interest rate for subsidized Stafford loans, 2.93% for unsubsidized Stafford loans, and 3.93% for all PLUS loans. xvii In contrast to the House Republican proposal, Obama does not place a cap on interest rates. He would also expand the income based repayment program, lowering the cap for monthly payments on all outstanding student loans from 15% of a borrower s discretionary income to 10%. According to the CBO, the President s proposal costs $29.8 billion over the first five years but reduces the deficit by $6.7 billion over 10 years (FY13-23), because of their assumption that borrowers will pay higher rates than current law in the second five years as interest rates increase. CBO estimates that the IBR expansion scores as a $3.6 billion cost over 10 years, for net deficit reduction of $3.1 billion.

3. Numerous Senators including, Lamar Alexander (R-TN), Tom Coburn (R-OK), Richard Burr (R-NC), Elizabeth Warren (D-MA), Jack Reed (D-RI) and Dick Durbin (D-IL) have introduced legislation to reform the direct federal student loan system. There are some differences between these bills, but there is general agreement that a different approach should be used to set rates. None of the Senate bills have seen any legislative action to date. WHAT THE EXPERTS SAY 1. The Brookings Institute argues that interest rates should be indexed to the market, thereby removing the role politics currently plays in the student loan program. Interest rates below market rates represent subsidies to students, according to Brookings; and, subsidies should only be made available by programs that bring about the largest increases in student enrollment, such as grant programs. Grant programs, however, are subject to annual budget appropriations which are currently limited by caps on discretionary spending. Brookings also maintains that interest rates should be fixed for the entire life of the loan. This will shield students from the risk of sudden rate increases a fear that could prevent some students from taking out the loans they need to enroll in higher education. Finally, Brookings recommends a cap on interest rates to protect students from potential spikes in market-based rates. xviii 2. The Heritage Foundation argues that the federal government ignores key factors that should be used to calculate rates: how likely a student will be to pay back the loan, the student s academic major(s) and credit history, whether there is a co-signer to the loan, and the university the student attends. Because current rates do not account for these market risks, the cost of student loans to taxpayers is likely understated, Heritage contends. Taking into account these risks will make taxpayers aware of the true cost of the student loan program. Also, Heritage believes there should be no subsidy for the loan program. xix SEARCHING FOR COMMON GROUND There seems to be broad ideological agreement between Democrats and Republicans that student loan interest rates should be set based on the government s cost of borrowing with some amount of mark-up over that rate, rather than fixed at certain rates. The various proposals emanating from Congress and the White House do contain some differences, but these

differences are reconcilable. If Congress and President Obama fail to compromise, the interest rate for new subsidized Stafford loans will double on July 1. If our elected officials do choose to come together, they have the opportunity to forge a longer term sustainable student loan policy. However, the long-term sustainability of student loan programs has much less to do with interest rates than it does to principal who takes them out, how much do they borrow, and for what. Fundamental student loan reform legislation would deal with eligibility, underwriting, completion, and quality of educational programs, as well as the balance between offering repayment protections and limiting taxpayer exposure.

Endnotes i Federal Student Aid: Loan Programs Fact Sheet, Department of Education, available at http://studentaid.ed.gov/sites/default/files/federal-loan-programs.pdf ii Portfolio Summary, Department of Education, the Office of Federal Student Aid, available at http://studentaid.ed.gov/about/data-center/student/portfolio iii Ibid. iv The interest rates on Subsidized Stafford loans for undergraduates were higher prior July 1, 2011, depending on the academic year in which the loan was disbursed. In academic year 2010-11, the interest rate was 4.5%. v Trends in Student Aid, 2012, College Board, page 21, available at http://trends.collegeboard.org/sites/default/files/student-aid-2012-full-report- 130201.pdf vi Graduate Students: Federal Loan Programs in Current and Constant Dollars over Time, College Board, available at http://trends.collegeboard.org/student-aid/figures-tables/graduatestudents-federal-loan-programs-current-and-constant-dollars-over-time. vii Undergraduate Students: Federal Loan Programs in Current and Constant Dollars over Time, College Board, available at http://trends.collegeboard.org/student-aid/figurestables/undergraduate-students-federal-loan-programs-current-and-constant-dollars-over-time viii CBO May 2013 Baseline Projections for the Student Loan Program, Congressional Budget Office, available at http://www.cbo.gov/sites/default/files/cbofiles/attachments/44198_studentloanprograms.pdf ix Undergraduate Students: Federal Loan Programs in Current and Constant Dollars over Time, College Board. x Private Student Loans, Consumer Financial Protection Bureau and the Department of Education, page 15, available at http://files.consumerfinance.gov/f/201207_cfpb_reports_private-student-loans.pdf xi Student Loan Affordability: Analysis of Public Input on Impact and Solutions, Consumer Financial Protection Bureau, available at http://files.consumerfinance.gov/f/201305_cfpb_rfireport_student-loans.pdf.

xii http://cnsnews.com/news/article/ed-secretary-federal-subsidies-college-tuition-donot-increase-cost-tuition xiii Income Based Repayment Fact Sheet, Department of Education, available at http://studentaid.ed.gov/repay-loans/understand/plans/income-based. xiv Kayla Webley, Students, Your Loan Interest Rate Is About to Double, Time, March 20, 2012, available at http://business.time.com/2012/03/20/students-your-loan-interest-rate-is-aboutto-double/ xv Jonathan Weisman, Student Loan Bill Passes House, Setting Up Face-Off, New Yorj Times, May 23, 2013, available at http://www.nytimes.com/2013/05/24/us/politics/house-passesstudent-loan-bill-setting-up-showdown.html?_r=0. xvi Congressional Budget Office Cost Estimate: H.R. 1911 Smarter Solutions or Students Act, Congressional Budget Office, available at http://cbo.gov/sites/default/files/cbofiles/attachments/hr%201911_0.pdf. xvii Libby A. Nelson, A Rare Washington Compromise. xviii Matthew M. Chingos and Beth Akers, Policymakers Get Serious About Student Loan Interest Rates, Brookings Institute, May 10, 2013, available at http://www.brookings.edu/blogs/up-front/posts/2013/05/10-federal-student-loans-interest-ratechingos-akers xix Lindsey Burke, Looming Student Loan Interest Rate Hike: Prudent Next Steps, Heritage Foundation, May 14, 2013, available at http://blog.heritage.org/2013/05/14/looming-studentloan-interest-rate-hike-prudent-next-steps/