Subsidized Stafford Loans Obsolete and Regressive Due to New Income Based Repayment

Back in 2010, the National Commission on Fiscal Responsibility and Reform (aka the Simpson-Bowles commission) recommended as part of its deficit and debt reduction proposal that policymakers end the interest-free benefit on Subsidized Stafford student loans. These loans are a subset of student loans awarded to borrowers who meet an income and cost-of-attendance formula test. The proposal was met with howls from student and borrower advocates who rushed to point out that students would leave school with more debt if policymakers eliminated the interest benefit, which stops the interest clock while borrowers are enrolled in school and, in some cases, for up to three years after.

Nevertheless, upon the request of the Obama Administration, Congress ended the benefit for graduate students in 2011, and moved the money to Pell Grants. That left the benefit intact for undergraduates, but probably not for much longer. It costs a whopping $4 billion a year, while the Pell Grant needs an extra $5.8 billion next year and $8.9 billion the following year to stave off a cut in benefits.

If lawmakers end the Subsidized Stafford interest benefit for undergraduates to provide more funding for Pell Grants—and they should—expect student and borrower advocates to again argue that the changes will increase student debt burdens. Except this time, the critics will have to include a big caveat that will undermine their case.

Subsidized Stafford loans now provide regressive benefits. That is, they target benefits to borrowers earning higher incomes in repayment. That is due to the new Income-Based Repayment (IBR) plan for federal student loans that took effect this month.  

The new plan (“New IBR”) sets a borrower’s payments at 10 percent of discretionary income and forgives any debt after 20 years. Those benefits effectively make Subsidized Stafford loan benefits redundant for borrowers who earn a lower or middle income in repayment.[1] Borrowers earning higher incomes, on the other hand, will still earn benefits from Subsidized Stafford loans in the form of reduced total payments.

Here is another way to understand this point. Borrowers will leave school with higher loan balances if policymakers eliminate the interest-free benefit on Subsidized Stafford loans. However, borrowers’ monthly and total payments under IBR are based on their incomes, not loan balances, and because the repayment term is set at 20 years (loan forgiveness) regardless of loan balance, New IBR ensures that the only borrowers who make higher payments as a result of having a higher loan balance are those with higher incomes.  

At what income level does this matter? There isn’t a magic number, but undergraduates are limited in how much federal loans they can take out. That allows us to run scenarios through the New America Foundation IBR calculator and see what borrowers will pay on their loans based on set income profiles, with and without the interest-free benefit on Subsidized Stafford loans.[2] The results are displayed in the table below.

In this analysis, we first assume the borrower’s debt is the maximum amount that a dependent undergraduate can borrow if he is 1) eligible for the full amount of Subsidized Stafford loans, plus the remaining amount of Unsubsidized Stafford loans, plus accrued interest while in school or 2) if he is eligible only for Unsubsidized Stafford loans plus accrued interest. The resulting loan balance at graduation after five years of borrowing under the first option is therefore $33,448, of which $23,000 is in Subsidized Stafford loans; and under the second, is $39,296, all in Unsubsidized Stafford loans.

Next we developed five borrower profiles, each with a different starting income and income growth rate. Borrower 1 has a starting income of $22,000 that increases by three percent every year, up to $38,577 in year 20. Borrower 2 has a starting income of $40,000 that increases by three percent every year, ending at $71,400 twenty years later. Borrower 3 has a starting income of $25,000 that increases by nine percent annually, reaching $128,542 in year 20. Borrower 4 has a starting income of $50,000 that increases by three percent every year, ending at $87,675 in year 20. Borrower 5 has a starting income of $40,000 and increases six percent each year, reaching $121,024 after twenty years.

As the table shows, under New IBR, the only borrowers who benefit from the additional benefits of Subsidized Stafford loans are those who earn a middle income right out of school, or those who eventually make a high income. Even then, the borrowers reap the benefit of a Subsidized Stafford in their last payments, not in their first years out of school. Their payments under IBR are based only on their incomes, not their loan balance, loan type or interest rate.

This brings up another key point. Not only are the added benefits of a Subsidized Stafford loan regressive, but borrowers earn the benefits in the form of a shorter repayment term—their final year(s) of repayment. Therefore, they collect a benefit when they theoretically are most able to repay.[3]

In short, with the availability of New IBR, Subsidized Stafford loans provide no additional aid to borrowers who need it most, while reducing payments for borrowers who are not struggling to repay. That should help persuade lawmakers and the student aid advocacy community that it would be prudent policy to end the Subsidized Stafford benefit and use the money instead to aid lower income college students through the Pell Grant program. The New IBR plan is now by far the most beneficial repayment plan available to low-income borrowers, so much so that it renders other, more poorly targeted benefits obsolete.

President Obama should include that policy proposal in his forthcoming budget request to Congress, citing the benefits of his administration’s New IBR as the justification for ending Subsidized Stafford loans.

There’s another lesson in here, too. Federal student aid is an incoherent mix of complex benefits and rules that overlap and cancel each other out in ways that virtually no one understands. For that we may thank the lawmakers (and the advocates who encourage them) who have added to, tweaked, and changed eligibility rules for these programs time and time again without even a hint of a broad plan. It’s time for a wholesale redesign of federal student aid.