Direct Lending

In his State of the Union address, President Obama called on Congress to prevent federal student loan interest rates from doubling later this year. This is the culmination of decades of legislative changes to the federal student loan program. Few people are aware of the policies that led to the pending student loan interest rate increase and many question whether the 6.8 percent fixed interest rate charged on the most widely-available loans provides a real benefit to students.

The Federal Education Budget Project today released an issue brief regarding federal student loan interest rates. This issue brief details the history of interest rates on federal loans, including the decisions that led to today’s fixed rates and the pending rate increase. It also examines the popular argument that current rates are unfavorable for borrowers and disputes the claim that student loans earn revenue for the government. 

The timeline below shows the interest rates on federal student loans taken out in each year, as well as the Congressional action that led to these interest rates. Roll over the points in the graph for more information.

In his State of the Union address, President Obama called on Congress to prevent federal student loan interest rates from doubling later this year. This is the culmination of decades of legislative changes to the federal student loan program. Few people are aware of the policies that led to the pending student loan interest rate increase and many question whether the 6.8 percent fixed interest rate charged on the most widely-available loans provides a real benefit to students.

The Federal Education Budget Project today released an issue brief regarding federal student loan interest rates. This issue brief details the history of interest rates on federal loans, including the decisions that led to today’s fixed rates and the pending rate increase. It also examines the popular argument that current rates are unfavorable for borrowers and disputes the claim that student loans earn revenue for the government. 

The timeline below shows the interest rates on federal student loans taken out in each year, as well as the Congressional action that led to these interest rates. Roll over the points in the graph for more information.

In his State of the Union address, President Obama called on Congress to prevent federal student loan interest rates from doubling later this year. This is the culmination of decades of legislative changes to the federal student loan program. Few people are aware of the policies that led to the pending student loan interest rate increase and many question whether the 6.8 percent fixed interest rate charged on the most widely-available loans provides a real benefit to students.

Segment Transcript:

Kai Ryssdal: We're probably still a couple of lawsuits away from figuring out exactly how much power the Consumer Financial Protection Bureau's eventually going to have. Senate Republicans say they're going to challenge President Obama's recess appointment of Richard Cordray to run the agency. The president says he did it because without a permanent director, the bureau couldn't do key parts of its job. One big part of which is regulating what're called non-bank activities -- check cashing, debt collection, payday lending.

This week everyone has been talking about student loans. The Obama administration announced some minor changes to the Direct Loan program. Separately, the House Education and Workforce Committee held a hearing to examine the program’s performance since Congress ended the bank-based guaranteed loan program last year. At the same time, some “Occupy Wall Street” protestors have been demanding relief from student loans. With all this attention on federal student loans, the direct-loans-are-profitable-for-the-government argument has been out in full force.

For example, at the House hearing Rep. John Kline (R-MN) said an interest rate of “6.8 percent when the federal government is borrowing at less than 1 percent can create a pretty big slush fund.” Democrats on the committee agreed with Kline that the government is earning money off of the program but argued lawmakers should consider lowering the interest rate that students pay to no more than what it cost the government to borrow and pay for loan defaults.

Generally, liberals, student advocates, and lobbyists for colleges say that Direct Loan profits suggest that the government is “overcharging students.” To conservatives and student loan companies, Direct Loan profits mean the government is competing with private businesses in providing a for-profit service.

Those would all be valid arguments except for the fact that the Direct Loan program doesn’t make money and it isn’t profitable.

This week everyone has been talking about student loans. The Obama administration announced some minor changes to the Direct Loan program. Separately, the House Education and Workforce Committee held a hearing to examine the program’s performance since Congress ended the bank-based guaranteed loan program last year. At the same time, some “Occupy Wall Street” protestors have been demanding relief from student loans. With all this attention on federal student loans, the direct-loans-are-profitable-for-the-government argument has been out in full force.

For example, at the House hearing Rep. John Kline (R-MN) said an interest rate of “6.8 percent when the federal government is borrowing at less than 1 percent can create a pretty big slush fund.” Democrats on the committee agreed with Kline that the government is earning money off of the program but argued lawmakers should consider lowering the interest rate that students pay to no more than what it cost the government to borrow and pay for loan defaults.

Generally, liberals, student advocates, and lobbyists for colleges say that Direct Loan profits suggest that the government is “overcharging students.” To conservatives and student loan companies, Direct Loan profits mean the government is competing with private businesses in providing a for-profit service.

Those would all be valid arguments except for the fact that the Direct Loan program doesn’t make money and it isn’t profitable.

The Direct Loan program issues about $100 billion in new student loans each year with over $500 billion in loans currently outstanding. The program charges undergraduates fixed interest rates between 3.4 percent and 6.8 percent. Graduate students get the same rates, but can borrow additional amounts at 7.9 percent interest rates under the Grad PLUS program. All students qualify for at least some type of loan regardless of their financial need. Repayment plans can be as long as 30 years and borrowers experiencing “economic hardship” can postpone payments for up to three years under deferment and forbearance policies, or can repay under income-based repayment plans. The government also forgives loans under a number of circumstances.

It’s common knowledge that banks make money by borrowing at low interest rates and making loans at higher rates. In the most basic sense that is a fair characterization. Many people therefore assume that Direct Loans are profitable for the government because the fixed interest rates borrowers pay are twice as high (or more) as what it costs the government to borrow.

But if the profitability of the loans is simply equal to the difference between these two interest rates, why don’t private banks make student loans at the same terms as the government? They can borrow at low rates too.

Take a look at the interest rate banks pay on savings accounts. It’s less than a third of a percent. A ten-year certificate of deposit pays 2.5 percent interest. Those rates are pretty close to U.S. Treasury rates, and they should be – bank deposits are insured by the federal government. They are certainly lower than the interest rate the government charges on student loans. But you won’t see your local non-profit credit union offering terms as good as a federal Direct Loan. That is because banks believe making loans at those interest rates and with those types of repayment plans is too risky relative to what the bank can expect to get in return. In other words, private banks are not willing to take on the risk associated with these loans at such low interest rates.

Of course, there are far more technical and complicated ways to explain why Direct Loans don’t make money, but we will leave those for another time. For now, take it as proof that not even the most efficient, most profitable banks in the country make loans as generous as those in the Direct Loan program because it is a money-losing endeavor.

It’s not bad, however, that the loans don’t make money. They aren’t supposed to. In fact, the government’s loss on the loans serves as a subsidy for the student who borrows to pay for school. According to a 2010 Congressional Budget Office study(page 10), the typical student gets a 12 percent subsidy on his federal Direct Loan. Put another way, the borrower receives a government benefit worth 12 percent of the amount he borrows. A $5,000 loan, therefore, provides a $600 government benefit to the student.

Regardless of these facts, any debate about federal student loans will inevitably be based on the false premise that the loans are profitable for the government. When the interest rate on subsidized Stafford loans jumps from 3.4 percent to 6.8 percent next school year, you can be sure there will be cries of usury. And as the Obama administration makes the case that the incentives it offers students to switch their loans over to the Direct Loan program save money overall, you can be sure some lawmakers will claim all of those savings come from profits earned off of students. Neither argument is true.

President Obama announced on Wednesday that the U.S. Department of Education will encourage millions of student loan borrowers to convert loans they borrowed through the Federal Family Education Loan (FFEL) program into direct lending. At Higher Ed Watch, we are pleased that the administration is moving ahead with this plan, which aims to help borrowers who are stuck with student loans under both the FFEL and Direct Loan programs.

The initiative, which will get underway in January, will provide some savings to borrowers who take advantage of it by providing them with up to a 0.5 percent interest rate reduction on their federal loans. But the administration's primary purpose is to simplify the repayment process for borrowers who currently have to make payments on their federal student loans to multiple loan servicers each month.

As readers of Higher Ed Watch know, the Democratically-controlled Congress last year eliminated the FFEL program and shifted to 100 percent direct lending. While the transition has gone remarkably smoothly, nearly six million borrowers have found themselves with loans in both programs, creating an administrative burden for these individuals, as well as for colleges and the federal government.

Many of the reporters who covered yesterday's House of Representatives hearing on the Direct Student Loan program appear to have missed the main story: the utter failure of the Republican leaders of the House Committee on Education and the Workforce to make their case that the U.S. Department of Education has mismanaged the transition to 100 percent direct lending.

In fact, by the end of the two-hour hearing, the House committee’s leaders were forced to acknowledge the Education Department’s success in shifting thousands of colleges out of the Federal Family Education Loan (FFEL) program and into direct lending without any meaningful disruption in service.

“I am glad to see that the transition has gone pretty well,” the education committee’s chairman John Kline (R-MN) said. At the conclusion of the hearing, Rep. Virginia Foxx (R-NC), the chairwoman of the panel’s higher education subcommittee, commended the Education Department “for what it’s done.”

This was a remarkable reversal, considering that the original intention of the hearing -- which was entitled “Government-Run Student Loans: Ensuring the Direct Loan Program is Accountable to Students and Taxpayers" -- was to bash the Education Department.

By Leo Kornfeld

The Department of Education recently announced that the national student loan default rate has risen to over 8 percent and we know that this measure provides only a limited view of the troubles that borrowers are having repaying their student loan debt. In the current economy, we can only expect things to get worse unless the Education Department tackles this problem head-on.

Among the defaulters are a large percentage of unemployed college students. It’s bad enough to be unemployed; however, when you add to this difficulty with being classified as a defaulter, you are really in trouble. Defaulting on federal student loans results in a lifetime of financial purgatory -- it destroys your credit, making it impossible to obtain a credit card, car loan, and home loan, and it puts you at risk of having your wages garnished, and your tax refunds intercepted by the IRS.

This disaster however can be avoided because there are options available for low income, unemployed college students and others to avoid going into default on federal loans. However, the Education Department has not done nearly enough to communicate these options so that the borrowers, who are already suffering in this difficult economy, fully understand they have alternatives to facing the lifetime punishment of being classified as a defaulter.

The debt ceiling legislation that Congress approved this month provided a one-time infusion of $17 billion for the Pell Grant program, spread between fiscal years 2012 and 2013. But as we’ve previously reported, the program is not out of the woods yet. Congressional appropriators still need to find at least another $1.3 billion to maintain the current maximum grant of $5,550 in the 2012 fiscal year, which starts in October.

Finding the money to cover this gap may not be as difficult as it seems. President Obama has offered a proposal that would not only provide the bulk of the savings needed but would also be of great help to millions of student loan borrowers. Unfortunately, the student loan industry’s Republican friends in Congress may stand in the way of this common-sense proposal.