Interest rates on federal student loans will rise slightly next year. Loans to undergraduate students issued in the 2017-2018 academic year will be 4.45%, down from 3.76% currently. Standard graduate student loan rates will increase to 6%, while PLUS graduate student and parent loan rates will increase to 7%. While all of these rates represent an increase from the current year, all are still lower than they have been for most of the decade.
Preston Cooper/Forbes
One would think that higher interest rates on student loans would benefit taxpayers at the expense of student borrowers. But in reality, the exact opposite is true.
Since 2013, interest rates on federal student loans have moved directly with the yield of a 10-year US Treasury note, instead of being set by Congress at a fixed level. Theoretically, this ensures that the cost of the student loan program to taxpayers remains roughly constant. Since the federal government is in deficit, it must issue treasury bills to raise the marginal funds it needs to finance the initial costs of student loans. When government borrowing costs rise, interest rates on student loans also rise, and with them the future revenue of the loan program.
So even if interest rates on student loans go up, taxpayers’ net incomes might not go up because government borrowing costs have also gone up. But there is another wrinkle.
Under a traditional repayment plan, a borrower’s monthly payments rise and fall with their balance and interest rate. For example, a borrower with an undergraduate loan balance of $25,000 makes annual payments of $2,503 at current interest rates and $2,585 at next year’s rates. But a new type of financial invention – the income-based repayment plan (IBR) – completely decouples monthly payments from interest.
Under the IBR, all eligible borrowers, regardless of balance or interest rate, make annual payments equal to 10% of their Discretionary Income. After making 20 years of payments, any remaining balance on their loans is forfeited.
For borrowers with small balances, the IBR sometimes doesn’t offer much value, as it involves longer repayment periods – 20 years versus 10 years under the standard plan. But for borrowers with large balances (read: graduate students), it’s a godsend. Not only are monthly payments reduced, but many borrowers can see their balances wiped out after 20 years.
This advantage is obvious. But many observers have failed to understand another benefit of the IBR: it protects participating borrowers from rising interest rates. Since payments are tied to income, not balances or rates, a higher interest rate has no effect on monthly payments, all else being equal. But a higher interest rate means that more of your monthly payment applies to interest rather than director on the loan. At high interest rates, IBR payments may not even be enough to cover interest, which means principal balances keep growing and growing, until Uncle Sam forgives them.*
By my calculations, a typical borrower with a graduate degree and $60,000 in student loan debt at this year’s interest rates will pay approximately $79,000 over the life of the loan. After 20 years, he will receive approximately $38,000 in forgiveness. But under next year’s interest rateshis rebate would amount to approximately $54,000, while his total payments would remain exactly the same!
Under the IBR, a 0.7 point rise in interest rates means that a typical graduate borrower’s total payments will remain the same even if their discount increases by more than 40%. Einstein wasn’t kidding when he jokingly said that compound interest is the most powerful force in the universe.
This loan forgiveness bonanza is one reason the Congressional Budget Office predicts that graduate student loans, which have high balances, will drive the majority of the increased losses taxpayers will incur on loans. students over the next decade. This projection comes despite the fact that graduate student loans carry high interest rates, which are expected to increase further over the next few years.
Remember that when interest rates on student loans go up, so do government borrowing costs. But as the IBR keeps student loan repayments constant even as borrowing costs rise, the government’s net revenue from the student loan program will decline. It’s true: rising interest rates on student loans mean that taxpayers’ losses increase.
Only in the weird world of the federal government can rising prices increase losses.
There are a few implications to all of this. First, Congress cannot circumvent this problem simply by lowering student loan interest rates, since government borrowing costs will remain the same. The Federal Reserve might pursue lower interest rates in an effort to reduce Treasury borrowing costs, but that would lead to inflation. (Plus, the Fed’s benchmark interest rate is already close to zero.)
Second, rising interest rates will push more IBR borrowers into positive loan forgiveness territory. Once a borrower is on track to receive loan forgiveness, any additional loans they take out are essentially free money. (There are tax consequences to the pardon, but Congress is unlikely to let them go into effect.) For many graduate students, staying in school longer and pursuing even higher education will become very attractive. This will reduce labor market participation and contribute to credential inflation. Not to mention that taxpayers will have to foot the bill for all that free money.
Congress could limit these consequences by capping the amount of money that graduate students can borrow, or even by completely privatizing the federal graduate loan program. But as interest rates rise over the next few years, the consequences of inaction will multiply. Congress should pursue student loan reform now, while it still can.
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*Somewhat technical note: If you have a subsidized Stafford loan and use the IBR, the government pays part of your interest if your payments do not cover it in full. However, you must pay all accrued interest under the IBR for unsubsidized loans. The government also pays interest for both types of loans under another income-driven plan, REPAYE. The government paying a portion of a borrower’s interest reduces their loan forgiveness after 20 years, but either way they receive a subsidy from taxpayers. For the sake of simplicity, I am using unsubsidized loans and the IBR in my example, under which the government does not not help borrowers pay their interest. For more information, see here.
