The Real Student Loan Interest Rate: Don't Forget About Tax Deductions

Here’s an added wrinkle in the debate on federal student loan interest rates that has gone entirely unmentioned. Middle and lower income borrowers don’t actually pay the 6.8 percent interest rate on Unsubsidized Stafford loan or the 3.4 percent rate that is set to expire for Subsidized Stafford loans issued later this year. They pay something lower because the federal government rebates a portion of their payments in the form of a tax deduction. We at Ed Money Watch aren’t sure why this important point is largely ignored or dismissed in the policy debates.

Is it because the benefit is too limited to really matter to borrowers? Probably not.

The student loan interest tax deduction allows individuals making less than $60,000 a year, and those filling joint returns and making less than $120,000 a year, to deduct up to $2,500 in student loan interest payments from their taxable income.  Eligibility phases out for individuals earning between $60,000 and $75,000 or joint filers earning between $120,000 and $150,000. Moreover, it is an “above-the-line deduction” and is therefore available to all filers, including those who do not itemize.

Furthermore, the $2,500 maximum deduction is high enough that most borrowers with student loans pay far less than this in annual interest. At the 6.8 percent interest rate, an individual would have to have about $40,000 in loans to exceed $2,500 in annual interest in his first year of repayment. Nationally, students who graduate with a bachelor’s degree from a public institution and have taken out loans borrowed an average of $22,000. This means that most individuals will at some point take some portion of this tax deduction, and many will take it for the entirety of their loan repayment.

Perhaps the benefit just isn’t worth much to borrowers, so no one mentions it when discussing federal student loans. But a closer look shows that the benefit isn’t trivial.

Someone earning $30,000 a year pays 15 percent federal income tax on the last dollar he makes (i.e. the 15 percent marginal tax rate). When taking the interest deduction, this borrower lowers his student loan interest rate by 15 percent (i.e. the rate isn’t 6.8 percent but actually 5.78 percent). Someone making $60,000, on the other hand, pays 25 percent marginal income tax rate and therefore pays an interest rate of 5.1 percent (6.8 percent reduced by 25 percent, his marginal tax rate). These rates are even lower given that the federal tax deduction typically flows through to state taxes because most states simply base an individual’s taxable income on his or her federal tax return.

There’s also evidence that a lot of borrowers are eligible for the benefit and do, in fact, claim it.

A U.S. Department of Education longitudinal survey of 2008 college graduates found that, of those students employed one year after graduating, 75 percent make less than $49,000 a year (the other 25 percent make more than $49,000, but it’s impossible to know the percentage making under the $60,000 eligibility threshold to qualify for the tax deduction). Therefore, at least 75 percent of employed students one year out of college in this survey would have qualified for the deduction if they paid interest on student loans.

What is more, over 8.5 million tax returns claimed this deduction in 2006, according to IRS data cited by the Congressional Research Service. That’s the number of returns, meaning that the number of people with student loans benefitting from the deduction is likely even higher.  In 2010, the student loan interest tax deduction reduced the taxes student loan borrowers owed by almost a billion dollars.

The lack of debate over the interest rate deduction is all the more surprising given some of the policy’s shortcomings. That is, it’s regressive (i.e. the higher an individual’s tax bracket, the more the benefit is worth); borrowers generally have to wait until they file taxes to get the benefit instead of simply paying a lower interest rate on their student loans; and it of course doesn’t help those who have no taxable income with which to claim the deduction.   

As policymakers continue to debate what the “right” student loan interest rate is, they shouldn’t ignore the student loan interest deduction. It’s a valuable benefit, with a few flaws.