GAO On Setting Student Loan Interest Rates: It Depends

Some Senate Democrats ought to be sporting t-shirts this week that read, “I wanted to cut interest rates on federal student loans to 1 percent and all I got was this lousy GAO report.”

Last Friday, the Government Accountability Office (GAO) released a report on federal student loan interest rates meant to bolster the claim that the right interest rate to charge on federal student loans is one where the federal government breaks even, neither making nor losing money. That rate is likely much lower, they argue, than the rates set under the Bipartisan Student Loan Certainty Act, which President Obama signed into law last year.

The law sets fixed interest rates on student loans equal to the rate on the 10-year Treasury note plus a fixed mark-up. For undergrads the markup is 2.05 percentage points, which means the fixed rate on loans issued for this school year is 3.86 percent. On loans issued next year it will probably be about 4.75 percent. That’s a pretty good deal, especially compared to a student loan interest rate in the private market, or compared to the 6.8 percent rate that the program charged on Unsubsidized Stafford loans prior to the new formula. It’s an even better deal when you consider that all undergraduates are entitled to a loan at virtually any school, no questions asked, and they can spread out payments over 20 years based on a small share of their incomes. No private lender would offer those terms at any interest rate.

Moreover, the interest rate for undergraduates now matches those on new 15-year mortgages (comparable in duration to the average student loan). But of course, to get a 3.9 percent rate on a mortgage, a borrower needs a good credit history, an income that will easily support the debt, a 20 percent down payment, and yes, a house to pledge as collateral. Meanwhile, the student loan program makes loans on a no-questions-asked basis.

Despite the fact that the new formula sets below-market rates as good as those on home mortgages, a few Senate Democrats think the rate should be lower still. They opposed the bipartisan compromise bill that ultimately passed last year.

How low, exactly, should the rates be? The senators didn’t say, but they offered a formula. The rate should be just high enough, they argued, to cover what the government pays to borrow to finance the loan, plus whatever it costs the government to administer the program, plus any losses from defaults and written off loans. They asked the Government Accountability Office (GAO) to estimate those costs and report the number.

On Friday the GAO came up with a 50-page answer to say basically, “we can’t answer that with just one number.” The title of the report says it all: Borrower Interest Rates Cannot Be Set in Advance to Precisely and Consistently Balance Federal Revenues and Costs. In other words, the cost of the program fluctuates, but when and by how much is based on what happens to interest rates in the economy in the future.  And the future is uncertain.

Of course, the GAO could have given a ballpark answer as to how interest rates could be set to approximately track the costs of the loan program, not precisely. For example, linking rates that borrowers pay to U.S. Treasury securities that match the term of the loan approximates the borrowing costs for the government. To estimate an interest rate that covers administrative costs and losses from defaults and write-offs, the GAO need only translate what the Department of Education reports for those costs into an annual rate that would be charged on a loan. The number is probably, at most, 1.00 percentage points. [1. The GAO reports that the annual administrative costs on a federal student loan is $25, which translates into about 0.20 percentage points in the form of an interest rate mark-up assuming the average balance on all outstanding loans is constant $12,000 balance. Next, default costs can be measured in the following way. The Department of Education says that about 18 percent of loans will default over the entire life of the cohort, which is about 12 years on average. Therefore, federal student loans default at a rate of 1.5 percent per year over the entire loan cohort life. The Department of Education reports that it collects about 80 percent of those defaulted loans, although it discounts those collections to the present using a risk-free rate. Thus the losses from defaults are, on a per-year basis, 0.30 percentage points (20 percent of the 1.5 percent of loans that default and are uncollected per year). Based on the Department of Education’s information, the interest rate markup therefore needs to include 0.30 percentage points to cover losses from defaults. Adding that 0.30 percentage points to the 0.20 percentage points to cover administrative costs results in a mark-up of just half a percentage point or 0.50. To get to the full 1.00 percentage point mark-up, assume that an additional 0.50 percent per year covers discharges for death, disability, Public Service Loan Forgiveness and Income-Based Repayment, although those costs are very hard to gauge and this figure is likely more than what the Department of Education estimates, rightly or wrongly.  Thus, a mark-up of 1.00 percentage points over the cost of financing the loan probably comes close to tracking the annual administrative costs, losses to defaults net of collections, and write-offs on federal student loans.]

If you think the government’s cost of financing the loan is equal to U.S. Treasury rates (I don’t, neither does the Congressional Budget Office, and ditto for a long list of academic economists) then to set break-even interest rates on student loans, simply add 1.00 percentage points to that rate.

Some senators have suggested that the interest rates on student loans should be variable, and therefore based on short-term Treasury securities, such as the 91-day bill. The rate on a 91-day Treasury bill is 0.06 percent, so by their formula the rate would be 1.06 percent this year.  But that could rise if short-term interest rates rise, since the student loan rate would be variable.

If the interest rate on the loan is fixed, it makes sense to use a long-term Treasury security, such as the 10-year note, like the formula now in place. Using the break-even formula, student loan interest rates would be set by the 10-year Treasury note plus 1.00 percentage points. That would result in a rate of 2.81 percent for loans issued in the current school year, a full percentage point lower than what undergraduates are getting now (although in terms of a monthly payment, that’s a difference of only $15 on a $25,000 loan).

Of course, you would have to accept that the cost of the loan program should be calculated as described above for that to be the break-even interest rate. Financial economists generally don’t and neither does the Congressional Budget Office. Even a non-expert should pause at the interest rate that formula suggests. It is an unbelievable feat to break even making loans to college students on a no-questions-asked basis when the interest rate you are charging is lower than what lenders charge the largest, safest, and most successful companies.

To be sure, the federal student loan program fulfills a crucial role in our higher education system. But faulty measures of what the program costs will only distort that system, not make it better. Maybe that’s why the GAO chose not to give Congress a straight answer.