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Is it Time to End the In-School Interest Subsidy on Student Loans?

Published:  November 11, 2010

The latest salvo has been fired in a long-running debate over the in-school interest benefits on federal student loans. Yesterday the National Commission on Fiscal Responsibility and Reform, a bipartisan panel President Obama created to identify policies that will improve the country’s fiscal situation, issued its draft proposal to shrink the deficit. The proposal includes eliminating the in-school interest benefit on federal student loans which would save $5 billion a year. This is one of over 50 suggestions that would achieve nearly $4 trillion in deficit reduction through 2020. The commission joins a wide range of stakeholders who have suggested that this benefit is just not good public policy.

At issue is a subsidy provided to a subset of students who take out federally-backed student loans, called Stafford loans. Remember, all federal student loans are subsidized. Undergraduate and graduate students from any income background can get loans with below-market interest rates and generous repayment plans – including deferrals, forbearances, interest-only and income based plans – courtesy of the government. But for undergraduates from lower income families and graduates students who have low incomes themselves, these loans also are interest free while they are enrolled in school. For the rest of students, their loans accrue interest every month when they are enrolled in school (albeit at the standard below-market rate), but it does not compound, and then is added to their loan principal when they leave school.

The upshot of the in-school interest rate benefit is that borrowers who qualify for it leave school with a lower loan balance. Practically speaking, these borrowers will make slightly lower monthly payments during 10 to 30 years of repayment.

So what’s not to like about this benefit? There must be something judging by the number of times and places policymakers and student aid experts have suggested getting rid of it.

The Congressional Budget Office (CBO) has made a habit of showing lawmakers in its biannual “Budget Options” publication how much the policy directed at graduate students costs. To be sure, the CBO doesn’t endorse or oppose any policies it puts in the publication, but the agency tends to gravitate toward well-founded and rational policy arguments when deciding which programs make the list. The proposal appears in the 2003, 2005, 2007, and 2009 editions.

In 2008, the College Board’s Rethinking Student Aid Study Group released a report on recommendations for reforming student aid that called for an end to the in-school interest benefit for both undergraduate and graduate students. Then in 2009, when Democrats on the House Education and Labor Committee released an initial draft of a major student aid bill, the Student Aid and Fiscal Responsibility Act, they too proposed an end to the in-school interest benefit for graduates students. Both the College Board and the House Democrats would have used the savings generated from ending the policy to boost other, more targeted federal student aid programs. Now the National Commission on Fiscal Responsibility and Reform report offers up the policy as part of its broader plan to reduce the deficit.

Most of these proposals point to the same shortcomings with the policy. First and foremost, the in-school interest subsidy is a back-end benefit that borrowers get slowly over the life of their loans – through slightly lower monthly payments. That means it’s not a “college access” program but a loan repayment program. The federal student loans already have lots of benefits built in to help students repay their loans that are more straightforward and obvious to borrowers, such as graduated repayment and income-based repayments plans. Why not roll the in-school interest benefit into boosting those other repayments plans?

Then there’s the issue of targeting the aid. Eligible undergraduate students generally are from lower income families. But it’s fair to ask why parental income should have any bearing on how much students should be required to pay each month on their loans 5, 10, or 20 years after leaving college. Or why graduate students, who by definition already have a college degree should get the interest subsidy. Moreover, loan subsidies that are based on a graduate student’s income while he or she is in school are a sad excuse for targeting aid to “needy students.”  A quirk in the formula used to calculate eligibility also lets students from higher income families get the benefit if they attend more expensive schools. Eligibility is not determined entirely by family income, but also by a family’s ability to cover tuition and other costs.

Nevertheless, the in-school interest subsidy lives on. College lobbyists and advocates for students generally oppose ending the benefit. And they were successful in getting House Democrats to drop the provision that would have ended the benefit for graduate students from the 2009 Student Aid and Fiscal Responsibility Act. But given the policy’s poor design and unclear purpose, it will always be low hanging fruit for both budget cutters and student aid reformers alike.

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