Three Years of Lower Student Loan Interest Rates: Borrowers Save $36 Billion

The results are in and interest rates on federal student loans are set to drop for the 2015-16 school year. Undergraduates will see rates drop from 4.66 percent to 4.29 percent. But this boon for borrowers almost wasn't. Student aid advocates and liberal Democrats in the Senate vehemently opposed the policy that caused rates to fall. More on that in a minute.

Why are interest rates going down? Two reasons. First, long-term interest rates in the U.S. economy and globally are lower compared with this time last year. The other reason is that back in 2013, Congress and president Obama changed the student loan program so that interest rates would reset annually based on… interest rates. In May each year the government sets the fixed interest rates on loans issued in the upcoming school year based on interest rates on 10-year U.S. Treasury notes, plus 2.05 percentage points (for undergraduate loans). For the record, we recommended this idea in 2012.

Before this policy, Congress picked an interest rate it liked and wrote it into law. Needless to say, that was a bad way to do it. It ensured that any rate was quickly out of sync with where interest rates in the economy were headed. Case in point: In 2002, Congress set the rate at a fixed 6.8 percent, but delayed implementing it until 2006, and then left it in place until 2013 for most loans to undergraduates. Meanwhile, between 2006 and 2013, interest rates on other types of loans plummeted to historic lows.

The new policy ensures that rates won't be out of sync again. And consider the rates it has set so far. For loans issued in the 2013-14 school year the rate was 3.86%; for those made in 2014-15 it was 4.66%; and for loan issued later this year and early next year it will be 4.29%.

While setting interest rates based on interest rates may seem like a sensible approach, advocacy groups and a few lawmakers opposed it. Senator Bernie Sanders of Vermont called it a “disaster for the young people in our country looking to go to college.” Senator Elizabeth Warren (D-MA) vocally opposed it as well.

They argued that rates would rise and students would end up paying more than if Congress just kept interest rates at an arbitrary 6.8 percent forever. That was a pretty big gamble on their part. How could they know 6.8 percent would be a better deal? They couldn’t, and for three years they’ve been terribly wrong. Had Congress listened to them and kept the 6.8 percent rate instead, undergraduates taking out loans in the three years since the law was enacted would be on the hook for $36 billion more in interest payments over the life of the loans.*

Ironically, the benefits that the new policy is providing to borrowers might give the Republicans who overwhelmingly supported it some buyer’s remorse. Earlier this year the Congressional Budget Office said it didn't see rates for undergraduates rising above 6.8 percent under the new law anytime before 2026. That's a change from when the law was enacted. Then CBO thought rates would rise above 6.8 percent much sooner, making the law close to budget neutral as a result. That was a major selling point for Republican budget hawks in 2013. But with the latest developments in interest rates, the 2013 law has swung to a cost compared to prior law and therefore probably couldn’t pass today if brought up for a vote.

So far, many Republicans, Democrats, and advocates have been wrong about where interest rates would go, which is why pegging student loan interest rates to market rates was the right approach in the first place. Students are now $36 billion better off.

*Calculated by using total loan issuance for undergraduates, then increasing the balance by the origination fee, further increasing it for half the loans that accrue interest while in school, and then factoring total interest payments on the resulting balance over a 10-year repayment term."