Subsidized Stafford Loans Come at a Cost – Even at a Higher Interest Rate

The student loan interest rate debate will come to a head early this summer as the 3.4 percent interest rate on Subsidized Stafford student loans nears its July 1 expiration. When that deadline hits, the rate will revert to 6.8 percent, the rate currently charged on Unsubsidized Stafford loans. Last week, we published a piece detailing the half-dozen reform proposals currently floating around Capitol Hill and produced some takeaways on each. But there are still other misconceptions to clear up.

One of the current interest rate plans, Senator Elizabeth Warren’s (D-MA) proposal to reset Subsidized Stafford interest rates for just one year at the Federal Reserve bank lending rate of 0.75 percent, is perhaps the most controversial. Federal Education Budget Project Director Jason Delisle last week published an op-ed on Yahoo! Finance detailing one of the underlying problems with the plan: that the government already loses money on Subsidized Stafford loans. Delisle wrote:

What about Senator Warren’s claim that the government makes money off loans to low-income students?… She points to figures that the non-partisan Congressional Budget Office says “do not provide a comprehensive measure of what federal credit programs actually cost the government and, by extension, taxpayers.” In fact, when the budget office “accounts more fully… for the cost of the risk the government takes on when issuing loans,” it reports that Subsidized Stafford loans – those made to low-income students – cost taxpayers $12 for every $100 lent out, or $3.5 billion per year. If the loans cost $3.5 billion a year when the government charges a 6.8 percent interest rate, cutting the rate to 0.75 percent would more than triple that cost.

Warren’s claim that the government is profiting on student loans – and therefore that it should drop the interest rate it charges on federal loans for low-income students dramatically – is a rhetorical one. Delisle spoke to Dylan Matthews of The Washington Post’s Wonkblog to clear up the issue. Matthews writes:

Just like any institution, the CBO determines the cost of loans by “discounting all of the expected future cash flows associated with the loan or loan guarantee—including the amounts disbursed, principal repaid, interest received, fees charged and net losses that accrue from defaults—to a present value at the date the loan is disbursed.” To do that, it needs to settle on a “discount rate,” which is usually the expected rate of return on the loan in question. Banks and other private institutions generally estimate that by finding loans with similar risks and maturities to the one being evaluated, and then using those similar loans’ rates of returns.

The CBO does not do that. It discounts all government loans using the returns on Treasuries of similar maturity. So a 30-year student loan would be compared to a 30-year Treasury bond. But Treasuries are the safest bonds in the world... To capture the true risk of these loans, you’d need to discount using the rate of return for another loan with similar risk. Comparing them to Treasuries make them seem safe no matter what the actual risk.

The claims that student loans turn a profit for the government are based on unrealistic, rigged budgeting mechanisms. And looking at a fair accounting method, the one recommended by the CBO, it’s pretty clear that Subsidized Stafford loans are actually costing the government (and taxpayers) $12 for every $100 lent.  This may seem a wonky, insider issue, but with Congress under rigid fiscal constraints right now and members arguing that the U.S. needs to reign in the deficit, costs matter.

For more on how the government is losing money on these loans, check out this background page from the Federal Education Budget Project. You can also see the Wonkblog article here, and Delisle’s op-ed about Senator Warren’s proposal here.