Are lower interest rates the best path to a fairer and more efficient student loan program? From the rhetoric heard in Congress and on the campaign trail, the answer appears to be “yes.” But empirical evidence and economic theory show that lowering interest rates is a blunt, inefficient, and costly tool to increase school enrollment and reduce defaults. There are much better ways to achieve these important goals.
Let’s take a step back and examine why the government lends to students in the first place.
Education is an investment: it creates costs in the present, but offers benefits in the future. When students are in school, expenses include tuition, school supplies, and lost income. After-school benefits include increased income, better health, and longer life. To pay the costs of their studies, students need cash.
In a business transaction, a borrower may provide collateral to finance a potentially profitable investment. The collateral would include all capital goods used in the fledgling business, such as a building or machinery. Similarly, homeowners use their homes as collateral when they take out a mortgage.
Although there have been occasional efforts to offer student loans securitized by human capital (e.g., MyRichUncle[i]), none went beyond a small niche market. Indeed, it is very difficult for private parties to pledge (or even confirm) individual income.
This private market failure This is one of the reasons why the government plays an important role in education loans. Governments, through the income tax system, have the unique ability to measure and collect income.
Given that federal loans are intended to correct a capital market failure, how should they be designed? What interest rate should be charged? If providing liquidity is the sole purpose of the loan program, loans would be granted at an interest rate that covers the government’s cost of the loan. Taxpayers would seek neither to make money from these loans nor to subsidize them.
How do federal loans actually work? For some low-income student loans (direct subsidized loans), the interest rate is zero as long as the student is enrolled in university. For other loans, interest accrues while the student is enrolled. All borrowers pay interest on federal loans after leaving school. Interest rates on these loans are set by Congress, vary by loan program, and are hotly debated. Sometimes the rate was fixed in nominal terms and generated substantial subsidies for borrowers. In the late 1970s and early 1980s, when mortgage interest rates were in the double digits, the interest rate on student loans was set at 8%. This meant student loans were a great deal. Borrowing has increased, creating enormous costs for the government.
Today, interest rates on federal student loans are tied to Treasury bills. The Student Loan Certainty Act of 2013 ties interest rates to the 10-year Federal Treasury rate, plus a margin. For the 2015-2016 academic year, interest rates are 4.29% for undergraduate Stafford loans and 5.84% for graduate loans. These rates do not fluctuate over the life of a given loan.[ii] They differ by the year in which the loan is issued, but are then fixed for the life of a loan.
Could lowering these interest rates increase college enrollment? A lower interest rate reduces the lifetime costs of college, so a rational decision-maker would include this subsidy in a calculation of the lifetime present value of schooling.
However, evidence from behavioral economics suggests that tangible and projecting incentives to time of decision making are the most effective in changing behavior. Interest subsidies are not tangible when students decide to enroll in university: students receive the same funds whether the loan interest rate is 2%, 4% or 10%. The importance of an interest subsidy is an open question; I am not aware of any empirical study that estimates a causal relationship between college enrollment and the interest rate charged on student loans.
Can lower interest rates reduce defaults? In the standard mortgage-type payment system, a lower interest rate reduces the monthly payments needed to cover principal and interest. In this payment model, a lower interest rate could make loan repayments more manageable for some borrowers and thus reduce defaults. The effect is quite small, however, since loan repayments are largely determined by principal rather than interest. The ten-year payment on a $20,000 loan is $204 when the interest rate is 4.29% and drops only twenty dollars (to $184) if the interest rate is reduced to 2%.[iii] For a borrower in serious difficulty, reducing the payment by twenty dollars is unlikely to make much difference.
Although lower interest rates are unlikely to reduce defaults, they are extremely costly. Why? A general interest subsidy benefits all borrowers, including those with high incomes who have no difficulty repaying their loans. An interest rate subsidy is therefore a costly and poorly targeted tool to reduce defaults in a mortgage-type repayment system.
In an income-based reimbursement system, such as Pay as You Earn, payments are a fixed percentage of income.[iv] The interest rate does not enter into the calculation of the monthly payment; it only affects the length reimbursement. For a borrower with a given principal and lifetime income, a lower rate will reduce the time it takes to repay the loan.
In an income-tested repayment system, an interest subsidy arrives at the to finish repayment period: payments stop sooner than they otherwise would have. In a 20-year repayment plan, for example, that means a borrower can stop paying when they’re 42 instead of 43. But those are peak income years, when the risk of failure is relatively low. And while this early cessation of payments helps those with low incomes even in their 50s, it also benefits borrowers who have reached very high incomes. An interest rate subsidy is therefore an expensive and poorly targeted tool to reduce defaults in an income-tested repayment system.
If we want to increase college attendance by lowering its price, evidence shows that scholarships and lower tuition fees are the right policy tools.[v] Cutting interest rates on student loans won’t get more students into college and will siphon off grant revenue that can’t do this important work.
If we want to reduce student loan distress and default, cutting interest rates is also the wrong policy. It does little for borrowers in difficulty while offering exceptional gains to those who have no trouble repaying their loans. A well-designed, income-based repayment plan allows borrowers to repay their loans when and if they can and is the best way to reduce defaults and distress.[vi]