Reduce or Eliminate Subsidized Loans for Undergraduate Students

Background

The William D. Ford Federal Direct Loan Program lends money directly to students and their parents to help finance postsecondary education. Two types of loans are offered to undergraduate students: subsidized loans, which are available only to undergraduates who demonstrate financial need, and unsubsidized loans, which are available to undergraduates regardless of need (and to graduate students as well).

For undergraduates, the interest rates on the two types of loans are the same, but the periods during which interest accrues are different. Subsidized loans do not accrue interest while students are enrolled at least half time, for six months after they leave school or drop below half-time status, and during certain other periods when they may defer making repayments. Unsubsidized loans accrue interest from the date of disbursement. The program's rules cap the amount—per year, and also for a lifetime—that students may borrow in subsidized and unsubsidized loans. By the Congressional Budget Office's estimates, subsidized and unsubsidized loans will each constitute roughly half of the dollar volume of federal loans to undergraduate students for the 2018-2019 academic year.

Option

This option includes two possible changes to subsidized loans. In the first alternative, only students who were eligible for Pell grants would have access to subsidized loans. (In the 2015-2016 academic year, about two-thirds of subsidized loan recipients received Pell grants, CBO estimates.) In the second alternative, subsidized loans would be eliminated altogether. In both alternatives, students would be able to borrow additional amounts in the unsubsidized loan program equal to what they were eligible to borrow in the subsidized loan program.

The Federal Pell Grant Program provides grants to help finance postsecondary undergraduate education; to be eligible for those grants, students and their families must demonstrate financial need. Under current law, only students with an expected family contribution (EFC)—the sum that the federal government expects a family to pay for a student's postsecondary education—of less than about $5,575 are eligible for a Pell grant. However, students with a larger EFC are eligible for subsidized loans as long as the EFC is less than their estimated tuition, room, board, and other costs of attendance, adjusted for other aid received. Under the first alternative, those students with a larger EFC would no longer qualify for subsidized loans.

Effects on the Budget

When estimating the budgetary effects of proposals to change federal loan programs, the Congressional Budget Office is required by law to use the method established in the Federal Credit Reform Act (FCRA). Under FCRA accounting, projected cash flows—including projected flows after 2028—are discounted to the present value in the year the loan is taken out using interest rates on Treasury securities. (Present value is a single number that expresses a flow of current and future payments in terms of an equivalent lump sum paid today and that depends on the rate of interest, or discount rate, that is used to translate future cash flows into current dollars.)

FCRA accounting, however, does not consider all the risks borne by the government. In particular, it does not consider market risk—which arises from shifts in macroeconomic conditions, such as productivity and employment, and from changes in expectations about future macroeconomic conditions. The government is exposed to market risk because, when the economy is weak, borrowers default on their debt obligations more frequently, and recoveries from borrowers are lower. Under another method, the fair-value approach, estimates are based on market values—market prices when they are available, or approximations of market prices when they are not—which better account for the risk that the government takes on. As a result, the discount rates used to calculate the present value of higher loan repayments under this option are higher for fair-value estimates than for FCRA estimates, and the savings from those higher repayments are correspondingly smaller.

According to the FCRA method, under current law the direct loan program would produce $18 billion in budgetary savings from 2019 to 2028, CBO estimates, and the option would produce additional savings of $7 billion under the first alternative and $22 billion under the second alternative. According to the fair-value method, under current law the direct loan program would cost $212 billion over the same period, and under the option those outlays would be reduced by $5 billion under the first alternative and by $17 billion under the second. This option would only affect new borrowers after July 1, 2019, so savings would rise over time because each new cohort of loans would include a larger share of new borrowers.

Under both alternatives, CBO expects that most of the affected students would continue to borrow through the unsubsidized loan program. However, not all of them would borrow as much in unsubsidized loans as they would have in subsidized loans because interest on unsubsidized loans starts to accrue earlier, from the date the loan is disbursed.

Under current law, CBO estimates that annual borrowing under the subsidized loan program would rise from $22 billion in 2019 to $30 billion in 2028. The option would gradually reduce the number of students who could take out subsidized loans. Under the first alternative, the volume of new subsidized loans would fall gradually over the 2019-2028 period and be $10 billion lower in 2028 than it would be under current law, CBO estimates. The volume of unsubsidized student loans would be about $10 billion higher in 2028 than it would be under current law. Under the second alternative, almost no subsidized loans would be originated in 2028 and the volume of unsubsidized loans would be almost $30 billion higher in that year than it would be under current law.

Using the FCRA method, CBO projects that the federal government incurs a cost of about $0.13 for every dollar of subsidized loans and a smaller cost—about $0.02—for every dollar of unsubsidized loans, because interest on an unsubsidized loan accrues from the date a loan is disbursed. To determine the government's savings, CBO calculates the amount that students would borrow in unsubsidized loans because they did not have access to subsidized loans, multiplied by the difference in cost ($0.11). Next, it calculates the amount the government would save from subsidized loans that would not be replaced (because some students would find unsubsidized loans too expensive). That figure is reached by multiplying the volume of such loans times $0.13. CBO adds the two figures together to estimate savings under FCRA. (Under the fair-value method, the same calculations are made except for the estimates of the loans' costs: $0.31 per dollar for subsidized loans and $0.23 per dollar for unsubsidized loans.)

The growth of enrollment, the path of future interest rates, the repayment plans borrowers will choose, the speed with which they will repay the loans, and the sensitivity of borrowers to the higher cost of unsubsidized loans are all sources of uncertainty in CBO's estimates. The sensitivity to cost is particularly important. Even for unsubsidized loans, the federal government provides a subsidy. So the fewer students who substitute unsubsidized loans for the subsidized loans that would no longer be available, the greater the reduction in federal costs.

Other Effects

If a student who would have borrowed $23,000 (the lifetime limit) in subsidized loans, beginning in the 2019-2020 academic year, instead borrowed the same amount in unsubsidized loans, that student would leave school with additional debt of about $3,700. Over a typical 10-year repayment period, the student's monthly repayment would be $41 higher than if he or she had borrowed the same amount in subsidized loans.

An argument in favor of this option is that the current program does not focus resources on people with the greatest needs as effectively as Pell grants. Also, providing subsidies by not charging interest on loans for a period of time may induce students to take loans without fully recognizing the difficulty they will face in repaying them once that period ends. Another argument in favor of the option is that some postsecondary institutions may increase tuition in order to benefit from some of the subsidies that the government gives students; reducing subsidies might therefore slow the growth of tuition. If institutions responded in that way, they would at least partially offset the effect of higher borrowing costs on students' pocketbooks. Also, the prospect of higher loan repayments upon graduation might encourage students to pay closer attention to the economic value to be obtained from a degree and to complete postsecondary programs more quickly. And for most college students, $41 a month in additional costs is small compared with the benefits that they obtain from a college degree.

An argument against this option is that students who face a higher cost of borrowing might decide against attending college, might leave college before completing a degree, or might apply to schools where tuition is lower but educational opportunities are not as well aligned with their interests and skills. Those decisions could eventually lead to lower earnings. Moreover, for any given amount borrowed, higher interest costs would require borrowers to devote more of their future income to interest repayment. That, in turn, could constrain their career choices or limit their ability to make other financial commitments, such as buying a home.