Options To Change Interest Rates And Other Terms On Student Loans

JUNE 2013is financially independent or not, and whether the borrower demonstrates financial need. The terms of theloans also differ in the amounts that can be borrowed,their interest rates, and the periods during which interestaccrues.Subsidized loans are available only to undergraduate students who demonstrate financial need as determined byprogram rules.3 Financial need depends in part on student and family income and in part on education costs.The amount that can be borrowed through subsidizedloans is limited, depending on the student’s year inschool, whether the borrower is financially independentor not, and the amount of other student financial aidreceived. Interest does not accrue on subsidized loanswhile a borrower is enrolled or for certain other periods;in contrast, interest does accrue on unsubsidized andPLUS loans from the date of origination. Unsubsidizedloans are available to undergraduate and graduate students (including students in professional degree programs) and are made without regard to financial need,although they too are subject to borrowing limits.Because of the borrowing limits on subsidized loans,many borrowers take out both kinds of loans–—subsidized and unsubsidized—which are expected to accountfor about 26 percent and 56 percent, respectively, of newdirect lending (by dollar volume) in 2013 (see Table 1).PLUS loans, the third category, are available to parents ofdependent students and to graduate students who havereached borrowing limits for other federal direct loans.Those loans are expected to account for about 18 percentof direct student loans in 2013.4Direct student loans carry either variable or fixed interestrates, depending on the date of origination. All subsidized, unsubsidized, and PLUS loans originated beforeJuly 1, 2006, had and continue to have variable interest3. Subsidized loans have been restricted to undergraduate studentssince July 2012. Before then, graduate students also could take outsubsidized loans.4. Borrowers with more than one loan can consolidate them intoa single obligation with a fixed interest rate that is a weightedaverage of the underlying loans’ interest rates and that is cappedat 8.25 percent. FCRA requires CBO to treat consolidations asmodifications to the terms of existing loans, not as new loans. Formore information about consolidation loans, see CongressionalBudget Office, The Cost of the Consolidation Option for StudentLoans (May 2006), www.cbo.gov/publication/17767.OPTIONS TO CHANGE INTEREST RATES AND OTHER TERMS ON STUDENT LOANS3rates that are indexed each July to the yield on the3-month Treasury bill. However, those rates are capped at8.25 percent for subsidized and unsubsidized loans andat 9.0 percent for PLUS loans. Loans originated on orafter July 1, 2006, carry fixed interest rates that rangefrom 3.4 percent to 7.9 percent; most have an interestrate of 6.8 percent. Rates on existing variable-rate loanshave fluctuated considerably over time in response tochanges in the Treasury’s borrowing rate, but the capshave dampened the variability that would have occurredin their absence. Because the Treasury’s borrowing ratesare currently low, the rates on existing variable-rate loansare below the rates on new fixed-rate loans.For most of the program’s history, interest rates were thesame for subsidized and unsubsidized loans. In July 2008,however, rates for new subsidized loans were set belowthose for new unsubsidized loans, and, in July 2011,the rate for new subsidized loans was set at 3.4 percent.That rate is scheduled to remain in effect until July 1,2013, when current law would return the rate to6.8 percent, thus again matching the interest rate onnew unsubsidized loans. No further rate changes arescheduled under current law: New subsidized and unsubsidized loans will carry a rate of 6.8 percent, and the rateon new PLUS loans will remain at 7.9 percent.The Cost to the Federal Government ofthe Direct Student Loan ProgramThe cost of the Federal Direct Student Loan Program isrecorded in the budget according to rules specified inFCRA.5 However, the FCRA methodology does notaccount for costs to taxpayers that stem from certain risksinvolved in lending—risks that private investors wouldrequire compensation to bear. Fair-value accountingincludes those costs and therefore generates a higher estimated cost of the program. Under either method, thecost to the federal government of student loans variesaccording to the type of loan: Unsubsidized loans cost thegovernment less (per dollar lent) than subsidized loansdo, and PLUS loans cost the government less thanunsubsidized loans.5. For a discussion of the FCRA methodology, see CongressionalBudget Office, letter to the Honorable Judd Gregg providing ananalysis of the subsidy costs of direct and guaranteed student loans(July 27, 2009), www.cbo.gov/publication/20774.CBO

4OPTIONS TO CHANGE INTEREST RATES AND OTHER TERMS ON STUDENT LOANSJUNE 2013Table 1.Characteristics of Various Types of Federal Direct Student LoansLoan TypeWho Is Eligible?Student LoanOriginations in 2013(Estimate)Billions of PercentageDollarsof TotalInterest Rate onNewly Originated Loans(Percent)July 2011– July 2013June 2013 and LaterDoes InterestAccrue DuringEnrollment orDuring CertainOther Periods?LifetimeBorrowing LimitSubsidizedUndergraduates withfinancial needa28263.46.8No 23,000UnsubsidizedUndergraduates andgraduate and professional59566.86.8Yes 31,000 for dependentundergraduate students,degree students,regardless of financial need 57,500 for independentundergraduates and 138,500 for graduate andprofessional students,minus any borrowing inunsubsidized loansbPLUSGraduate and professionaldegree students andparents of dependentundergraduates,regardless of financial needb19187.97.9YesNo limitcSource: Congressional Budget Office.Note: Excluded from this table are data for Federal Direct Consolidation Loans, which allow borrowers to combine two or more federalstudent loans for repayment as a single loan. The Federal Credit Reform Act of 1990 requires CBO to treat consolidation loans asmodifications to the terms of the existing loans, not as new loans.a. A student’s eligibility for subsidized loans is determined on the basis of the relationship between his or her family’s ability to pay and thecost of the student’s education. In particular, the Department of Education calculates each student’s expected family contribution (EFC),which depends on a family’s income and assets, and postsecondary institutions calculate each student’s cost of attendance (COA), whichincludes estimated tuition, fees, books, room, board, transportation, and other costs. A student is eligible for a subsidized loan, up to theannual borrowing limit, if the COA minus other financial aid is greater than the EFC.b. Dependent students generally are undergraduate students under the age of 24, unmarried, and with no dependents of their own.c. Borrowing is limited annually to the COA minus other financial aid.Budgetary CostUnder FCRA, the cost of federal loans—known as acredit subsidy—is recorded in the budget in the year theloans are disbursed. The credit subsidy is the net presentvalue of the federal government’s expected cash flows overthe life of a loan, using interest rates on Treasury securities of comparable maturity to discount the cash flows.6According to procedures established by FCRA, CBOprojects that student loans issued between 2013 and2023 will save the government a total of 184 billion(see Table 2).7CBOThe cost of the student loan program is projected to benegative in each year of the coming decade because ofthe difference between interest rates on government6. Net present value is a single number that expresses a flow ofcurrent and future income (or payments) in terms of an equivalentlump sum received (or paid) today. The present value depends onthe rate of interest (the discount rate) used in the calculation.7. Credit subsidies do not include administrative costs, which CBOprojects will be about 15 billion for direct student loans between2013 and 2023.

JUNE 2013OPTIONS TO CHANGE INTEREST RATES AND OTHER TERMS ON STUDENT LOANS5Table 2.Projected Outlays and Net New Lending Under the Federal Direct Student LoanProgram, by Fiscal Year(Billions of Net New *61114141515151695Memorandum:Outlays Estimated UsingFair-Value AccountingaSource: Congressional Budget Office.Notes: Negative values indicate budgetary savings.Outlays and net new lending are from Congressional Budget Office, “Student Loan Programs—May 2013 Baseline” (May 14, 2013),www.cbo.gov/publication/44198.* between - 500 million and 500 million.a. Outlays are credit subsidies calculated according to the procedures specified in the Federal Credit Reform Act of 1990 (FCRA), except thatthe procedure to calculate fair-value credit subsidies adds an amount to the discount rates specified by FCRA to account for certain risksthat the FCRA approach does not account for. Credit subsidies exclude administrative costs (including payments to Department ofEducation contractors and certain statutory payments for collection costs).b. Does not include - 15 billion in outlays attributable to credit subsidy reestimates on existing federal student loans that were disbursed inprior fiscal years.c. Net new lending excludes Federal Direct Consolidation Loans, which allow borrowers to combine two or more federal student loans forrepayment as a single loan. FCRA requires CBO to treat consolidation loans as modifications to the terms of the existing loans, not as newloans. Net new lending includes only those loan obligations for which at least one disbursement occurs. (Some students are approved fora loan but do not enroll in school.)borrowing and those on student loans. Specifically, thegap between those sets of rates is expected to be largeenough to produce enough savings to more than offsetthe anticipated cost to the government arising fromdelayed payments and defaults by some borrowers. However, the cost of the program is projected to become lessnegative—that is, the federal government’s savings areprojected to decrease—each year between 2013 and2018 before leveling off thereafter. That pattern arisesbecause interest rates on student loans will be constantthroughout the period under current law while the rateson Treasury securities will rise. For example, CBOprojects that the rate on 10-year Treasury notes will risefrom 2.1 percent in 2013 to 5.2 percent in 2018 as theeconomy strengthens. As a result, annual savings forthe student loan program are projected to fall from 37 billion in 2013 to 8 billion in 2018. (The amountfor 2013 is the budgetary cost of loans disbursed in 2013.CBO expects that the budget will also record savings of 15 billion this year as a result of reestimates of the costof student loans disbursed in earlier years; such creditreestimates for federal loans are made annually by theOffice of Management and Budget and the federalagencies responsible for lending programs.)Fair-Value CostAlthough the FCRA methodology accounts for expectedlosses from defaults, it does not account for the fact thatlosses from defaults tend to be highest when economicand financial conditions are poor—which is whenresources are scarcer and hence more valuable. The costof that “market risk” is excluded from FCRA estimatesbecause the FCRA methodology discounts expectedfuture cash flows at Treasury borrowing rates rather thanat higher interest rates that incorporate the cost of suchrisk.CBO

6OPTIONS TO CHANGE INTEREST RATES AND OTHER TERMS ON STUDENT LOANSFigure 1.JUNE 2013costly to the federal government in most years during thecoming decade. CBO projects that direct student loansissued between 2013 and 2023 would cost 95 billion ona fair-value basis, in contrast with the projected savings of 184 billion under FCRA accounting. Under eitheraccounting method, the program will be much less financially advantageous to the federal government in 2018and beyond than in 2013 (see Figure 1).9Projected Outlays for Federal DirectStudent Loans, Calculated UsingFCRA and Fair-Value Methodologies,by Fiscal Year(Billions of dollars)20Fair 192020202120222023Source: Congressional Budget Office.Notes: Outlays are credit subsidies calculated according to theprocedures specified in FCRA, except that the procedure tocalculate fair-value credit subsidies adds an amount to thediscount rates specified by FCRA to account for certain risksthat the FCRA approach does not account for. Creditsubsidies exclude administrative costs (including paymentsto Department of Education contractors and certainstatutory payments for collection costs).FCRA Federal Credit Reform Act of 1990.Credit subsidies estimated using the fair-value methodology represent a broader measure of cost that includesthe cost of market risk.8 The fair value of a student loanapproximates its value in a competitive private market,and a fair-value subsidy occurs whenever the governmentaccepts less stringent terms than private-sector lenderswould require to make comparable loans.Taking account of the cost of market risk significantlyreduces or eliminates the savings estimated for studentloans under the FCRA approach, making student loans8. See Congressional Budget Office, Costs and Policy Options forFederal Student Loan Programs (March 2010), www.cbo.gov/publication/21018. Because FCRA estimates do not includeadministrative expenses, and because such expenses areappropriated separately and recorded in the budget on a cashbasis, CBO’s fair-value estimates in this report exclude thoseexpenses as well.CBOOn a fair-value basis, CBO estimates, the student loanprogram will have a negative credit subsidy in 2013 and2014; that is, it will produce net budgetary savings. Thatnegative estimated subsidy might appear to imply thatprivate financial institutions could make a profit by offering student loans on the same terms or on better termsthan will be offered by the federal program under currentlaw. However, the federal government has tools that private lenders do not have for collecting repayments fromborrowers who have defaulted: The government can, forexample, deduct loan payments from the wages, federaltax refunds, and Social Security benefits of such borrowers. As a result, private firms might not find it profitableto offer student loans on the same terms as the federalgovernment, despite the negative estimated fair-valuesubsidies.10Credit Subsidy Rates for Different Types of LoansAs noted, the credit subsidy for a federal loan program isthe dollar amount the government disburses minus whatborrowers are expected to repay, expressed in presentvalue terms. The related measure of a credit subsidy rateis the ratio of the credit subsidy to the amount disbursed;it measures the cost of the program as a share of theamounts disbursed. As a simple example, if the programlent 10 and was repaid 8 in present-value terms, thecredit subsidy rate would be 20 percent. Because theamount disbursed is always positive, the credit subsidy9. The gap between FCRA and fair-value estimates of outlays fordirect student loans narrows during the 2013–2018 periodbecause the risk premium for interest rates that are incorporatedin fair-value estimates is projected to fall over that period aseconomic conditions improve. The risk premium is projected toremain constant after 2018, but the gap between outlays on fairvalue and FCRA bases is expected to widen slightly because theconstant projected difference in discount rates is applied to anamount of new lending that is projected to grow as more studentstake out loans.10. For additional discussion of possible explanations for negativefair-value subsidy estimates, see Congressional Budget Office,Fair-Value Estimates of the Cost of Federal Credit Programs in 2013(June 2012), pp. 6–7, www.cbo.gov/publication/43352.

JUNE 2013OPTIONS TO CHANGE INTEREST RATES AND OTHER TERMS ON STUDENT LOANS7Table 3.Projected Credit Subsidy Rates and Net New Lending for Various LoansUnder the Federal Direct Student Loan Program, by Fiscal YearType of redit Subsidy Rate (Percent) 7-22-610-7-22-6Net New Lending (Billions of 106109113117121124128132136140363477774732278145 1,371Source: Congressional Budget Office.Notes: Negative values indicate budgetary savings.Credit subsidy rates and net new lending are from Congressional Budget Office, “Student Loan Programs—May 2013 Baseline”(May 14, 2013), www.cbo.gov/publication/44198.a. The credit subsidy rate for a group of loans is the credit subsidy as a percentage of the amount of those loans. Credit subsidies arecalculated according to the procedures specified in the Federal Credit Reform Act of 1990 (FCRA); they exclude administrative costs(including payments to Department of Education contractors and certain statutory payments for collection costs).b. Net new lending excludes Federal Direct Consolidation Loans, which allow borrowers to combine two or more federal student loans forrepayment as a single loan. FCRA requires CBO to treat consolidation loans as modifications to the terms of the existing loans, not as newloans. Net new lending includes only those loan obligations for which at least one disbursement occurs. (Some students are approved fora loan but do not enroll in school.)rate will be positive or negative depending on whetherthe credit subsidy itself is positive or negative.The federal credit subsidy rates vary among the threetypes of loans. In each year between 2013 and 2023,CBO projects, subsidies will be substantially higher forsubsidized than for unsubsidized loans (for estimatesunder FCRA accounting, see Table 3). Although undercurrent law interest rates on new loans of both types willbe the same starting July 1, 2013, subsidized loans willcontinue to have higher subsidy rates because they do notaccrue interest while students are in school and duringcertain other periods.11Subsidy rates are substantially lower for PLUS loans thanfor unsubsidized loans primarily because PLUS loans11. Borrowers can defer payments under a variety of circumstances.For example, deferments are available to borrowers who areenrolled in school at least half-time, are receiving unemploymentcompensation, are in the military, or are in a disabilityrehabilitation program. No interest is charged for subsidized loansduring such deferments.have higher interest rates, although PLUS loans’ lowerprojected rates of delinquency and default and higherorigination fees also contribute to the lower subsidy ratesfor those loans.Options for Changing Interest Ratesand Other Terms on Student LoansThe interest rates and other terms of federal direct student loans could be changed in various ways that wouldaffect the cost of the program to the federal government,the cost of loans to students, and the year-to-year fluctuations in the rates paid by borrowe

student loans. All of those options would link interest rates on direct student loans to the rates paid on Treasury securities. One set of options would link rates on student loans to the rate for 10-year Treasury notes in the year a loan is disbursed—much like a fixed-rate home mortgage. Another set of options would reset the interest