Remove the Cap on Interest Rates for Student Loans

Background

Through the William D. Ford Federal Direct Loan Program, the federal government lends money directly to students and their parents to help finance postsecondary education. The interest rates on new student loans are indexed annually to the 10-year Treasury note rate. For undergraduate subsidized and unsubsidized loans, the interest rate is the 10-year Treasury note rate plus 2.05 percentage points, with a cap of 8.25 percent. For unsubsidized loans to graduate students, the interest rate is the 10-year Treasury note rate plus 3.6 percentage points, with a cap of 9.5 percent. Finally, for PLUS loans, which are additional unsubsidized loans to parents or graduate students, the rate is the 10-year Treasury note rate plus 4.6 percentage points, with a cap of 10.5 percent.

Option

This option includes two alternatives. The first would remove the interest rate cap on all graduate loans and PLUS parent loans. The second would remove the interest rate cap on all federal student loans. Both policies would take effect in the 2019-2020 academic year. Without the caps, student loan interest rates would be higher than under current law for undergraduate borrowers if the 10-year Treasury note rate was higher than 6.2 percent or for graduate and parent borrowers if it was higher than 5.9 percent.

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 was 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 an alternative 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 the option are higher for fair-value estimates than for FCRA estimates, and the savings from those higher repayments are correspondingly lower.

According to the FCRA method, eliminating the cap only on loans to graduate students and parents would reduce projected spending by $11 billion from 2019 to 2028, CBO estimates. According to the fair-value method, projected spending would decline by $8 billion.

According to the FCRA method, eliminating the cap on all federal student loans would reduce projected spending by $16 billion from 2019 to 2028. According to the fair-value method, projected spending would decline by $12 billion.

Both alternatives are projected to lower spending because there is some possibility that the interest rate caps could bind under current law, even though that outcome does not occur in CBO's 10-year economic projections. In other words, the estimates take into account the possibility that interest rates will be higher than expected. CBO estimates a range of possible outcomes for borrower interest rates using statistical techniques designed to capture the effects of volatility in interest rates. Specifically, such estimates are based on Monte Carlo simulations, a technique based on statistical inference regarding the uncertainty in estimates and projections of economic variables. That technique allows CBO to account for the probability in each year that the 10-year Treasury note rate will be high enough for the caps to be in effect.

Uncertainty around the possible outcomes for future interest rates is one key factor that makes the estimates of the two alternatives uncertain. Underlying the estimates is the probability that the Treasury rate will be high enough for student loan rates to be capped, which is based on CBO's April 2018 forecast of the Treasury rate. A greater probability of higher Treasury rates would increase the probability that the caps would bind. As a result, the estimated savings from this option would also increase. Likewise, a smaller probability of higher Treasury rates would decrease the probability that the caps would bind and, thus, the estimated savings would decrease.

Other Effects

An argument for this option is that the program's subsidy would depend less on the level of interest rates. In other words, the cost to borrowers would always increase when the government's cost of funding increases and any underlying subsidy would remain unchanged. Removing the caps would also prevent student loan borrowing from becoming cheaper relative to other borrowing, such as taking out a home mortgage, when Treasury rates are high.

An argument against this option is that borrowers would face higher costs to repay their loans if their loan interest rates were higher than the current caps. The Congress originally included the caps so that there would be a limit to borrowers' interest costs if Treasury rates increased to very high levels. If the caps were removed, the potential for such high interest rates could cause people who would need to take out student loans to choose not to attend college. In addition, such high interest rates could increase borrowers' default rates.