Options to Change Interest Rates and Other Terms on Student Loans

The Federal Direct Student Loan Program offers loans to students and their parents to help pay for postsecondary education. Under current law, about $1.4 trillion in new direct loans will be made to students between 2013 and 2023, CBO projects. Analysts and policymakers have raised concerns about various features of the program, including a jump in the interest rate on what are known as subsidized loans—which account for about one-quarter of all new student loans—that is scheduled to occur on July 1, 2013.

This report provides information about the direct student loan program and its effects on the federal budget under current law. It also presents an analysis of the expected budgetary effects of options for changing the terms on new subsidized student loans and of options for changing the overall approach to setting interest rates on all new direct student loans.

What Are the Budgetary Effects of the Federal Direct Student Loan Program?

CBO projects that the total cost to the federal government of student loans disbursed between 2013 and 2023 will be negative; that is, the student loan program will produce savings that reduce the deficit. Under rules established by the Federal Credit Reform Act of 1990 (FCRA), the cost of a student loan is recorded in the federal budget during the year the loan is disbursed, taking into account the amount of the loan, expected payments to the government over the life of the loan, and other cash flows—all discounted to a present value using interest rates on U.S. Treasury securities. Under FCRA’s rules, CBO estimates, savings from the program will be $184 billion for loans made between 2013 and 2023. The estimated savings are $37 billion in 2013 but will diminish over time to fall below $10 billion per year from 2018 through 2023. (That $37 billion in savings for loans originated in 2013 excludes savings of $15 billion that CBO expects to be recorded in the budget this year as a result of the Administration’s reassessment of the cost of student loans made in previous years.)

Because FCRA requires the discounting of future cash flows using rates on Treasury securities, the effect of the student loan program on the federal budget depends in part on the difference between two sets of interest rates: those paid by borrowers and those paid by the federal government on Treasury securities. Beginning in July 2013, the interest rates charged for all student loans will be 6.8 percent or 7.9 percent, depending on the type of loan. The government currently borrows at much lower rates; CBO expects the average for 10-year Treasury notes, for example, to be 2.1 percent during 2013. The large gap between the rates paid by student loan borrowers and those paid by the federal government is the source of the savings attributable to the program in 2013. The rates the government pays are expected to rise in coming years, however, thereby reducing the annual budgetary savings from the student loan program.

FCRA accounting does not consider some costs borne by the government. In particular, it omits the risk taxpayers face because federal receipts from interest and principal payments on student loans tend to be low when economic and financial conditions are poor and resources therefore are more valuable. Fair-value accounting methods account for such risk and, as a result, the program’s savings are less (or its costs are greater) under fair-value accounting than they are under FCRA’s rules. On a fair-value basis, CBO projects that the student loan program will yield $6 billion in savings in 2013 and will have a cost of $95 billion for the 2013–2023 period as a whole, compared with projected savings of $37 billion this year and $184 billion for the entire period on a FCRA basis.

How Would Setting Different Interest Rates Affect the Student Loan Program?

The federal government’s three main types of direct loans—subsidized, unsubsidized, and PLUS loans—are offered to different kinds of borrowers on different terms. The interest rate for subsidized loans is currently scheduled to double from 3.4 percent to 6.8 percent on July 1, 2013. Rates are currently higher for the other two types of loans—6.8 percent for unsubsidized loans and 7.9 percent for PLUS loans—and those rates are not scheduled to change. Analysts and policymakers have expressed concerns about the upcoming change in the rate on subsidized loans, the student loan program’s effect on the federal budget, year-to-year fluctuations in the cost of the program both to the government and to borrowers, and other issues.

CBO has assessed a range of potential ways that policymakers could alter the terms of subsidized loans:

• Keep the current rate of 3.4 percent on subsidized loans rather than allowing it to double as scheduled under current law. That option would increase the cost of the student loan program to the government by $41 billion between 2013 and 2023.
• Restrict access to subsidized loans to students who are eligible to receive Pell grants while allowing the interest rate to rise to 6.8 percent, or eliminate the subsidized loan program altogether. Those alternatives would increase the government’s savings during the 2013–2023 period by $21 billion and $49 billion, respectively.
• Keep the rate on subsidized loans at 3.4 percent and restrict access to subsidized loans to students who are eligible to receive Pell grants. That option would increase the cost of the student loan program to the government by $1 billion between 2013 and 2023.

CBO also considered options that would change the overall approach to setting interest rates on all new direct student loans. All of those options would link interest rates on direct student loans to the rates paid on Treasury securities. One set of options would link rates on student loans to the rate for 10-year Treasury notes in the year a loan is disbursed—much like a fixed-rate home mortgage. Another set of options would reset the interest rate annually—much like a variable-rate home mortgage—for student loans made on or after July 1, 2013. In those options, the rate would be linked to the current rate on the 1-year Treasury note.

Any of those options for changing the way that student loan interest rates are set would reduce year-to-year fluctuations in the amount the program costs the government. Whether that cost increased or decreased overall for the next decade would depend on which changes were made. Those options also would generate year-to-year changes in the interest rates that borrowers paid and could lead to high interest rates on student loans if rates on Treasury securities rose sharply. Costs to borrowers could be contained if caps were set for interest rates on student loans, although such caps also would increase the cost of the program to the federal government.