The Road to Cutting Student Loan Interest Rates

This week, Congressional Democrats will try to make good on their 2006 campaign promise to cut student loan interest rates in half. Higher Ed Watch will sketch out some of their options and comment on their actions.

Two weeks ago, we posted our assessment of the political landscape for cutting student loan interest rates in half. We stand by our view that Democrats want to deliver; that the Bush Administration cares more about renewing the No Child Left Behind Act and extending it into high schools than cutting student loan interest rates; and that Congressional Republicans are apt to advance two key political messages: (1) the Democrats are just "taxing and spending," and (2) "interest rates aren't the problem, skyrocketing tuition is the real problem."

In response to the first counter political message (that cutting student loan interest rates for borrowers amounts to more "taxing and spending"), we expect Democrats to trim the costs of their proposal and offer offsets, thereby requiring either little or no increase in taxation.

How might Congress trim the costs of cutting student loan interest rates in half?

1. Limit the Class of Loans for Which Interest Rates are Cut.

There are three main types of federal student loans, each with different interest rates set by law. Perkins loans carry a 5% annual interest rate. Not all colleges participate in the Perkins loan program. In fact, Perkins loans are disproportionately available to private college students. PLUS loans carry an 8.5% annual interest rate, but they are only available to parents or graduate students with good credit records. Undergraduate students cannot borrow PLUS loans. Finally, there are Stafford Loans that as of July 1, 2006 carry a 6.8% annual interest rate and are available to all students at virtually all colleges and universities.

In the 2006 campaign, Democratic candidates did not distinguish among these three types of student loans in making their pledge to cut interest rates in half. They could cut just one, Stafford loans, reasoning that: (a) fiscal realities keep them from cutting all three, and (b) it's most fair to cut only Stafford, because it's the most widely held loan. Nearly all Perkins and PLUS recipients hold Stafford loans as well, but the same is not true in reverse.

2. Limit an Interest Rate Cut to a Need-Based Subset of Stafford Loans.

Stafford loans are available in subsidized and unsubsidized forms. Generally speaking, in the case of subsidized Stafford loans, the government pays interest costs while the student is enrolled in school. For unsubsidized Stafford loans, interest accrues while the student is in school and is typically capitalized by the borrower. Subsidized Stafford loans therefore are much more costly to the government than unsubsidized Stafford loans, but are also targeted based on need via the FAFSA application process.

Fortunately for Congressional Democrats, it's not only poor students who receive subsidized Stafford loans. The middle class uses them as well. In fact, subsidized Stafford loan recipients can have family incomes stretching all the way up to $200,000 a year. (Note: It's exceptionally rare that family income of a subsidized Stafford loan borrower reaches as high as $200,000 a year. Such a phenomenon primarily occurs only when a student comes from a very large family and attends an elite, private college.)

3. Limit an Interest Rate Cut to Students Borrowing for their First and Second Years of College, but Not their Third and Fourth Years or Graduate Level Studies.

Borrowing for college or graduate school, particularly professional graduate school, is a very good personal investment. Lifetime earnings for college graduates are approximately $1 million higher than for high school graduates. But the difference between those with some college (i.e. college dropouts) and those with only a high school diploma is much, much less.

Unfortunately, nearly half of all students who begin a four year post-secondary education program do not graduate within six years of their initial enrollment. For the 50% of college students who drop out, up front borrowing for higher education has high social risks. First, they assume large debt. Second, without a degree, they're less able to obtain a high paying job that will enable them to pay off that debt without significant economic hardship.

From a social insurance standpoint, therefore, it makes most sense for the public to front load additional financial aid and make college less expensive for private individuals in the early years of their post-secondary training. Later year personal investments by individuals are more apt to result in private economic gain and thus less in need of additional public subsidy.

4. Limit an Interest Rate Cut to Students Who Work or Serve Their Communities an Average of 10 Hours a Week.

In general, America's financial aid system provides a great deal of help to students and families and asks little in return. But a work or service requirement attached to new, additional financial aid benefits makes sense substantively and politically.

Substantively, college students who work or serve an average of 10 hours a week report that they manage their time better, take their studies more seriously, and get better grades. Fifteen hours a week is a tipping point: more than that and students' studies suffer. But a little work seems to correlate with higher academic performance and arguably helps build better character.

Politically, Middle America is more likely to embrace the idea of extending additional taxpayer financial aid to students if it sees its values reflected in student behavior. It's not enough that a better educated workforce is in everyone's interest or that there is an inherent value in education. We at Higher Ed Watch think that Middle America wants to see its values reflected in public policy -- values like work, service, and reciprocity. Washington took a step in this direction a dozen years ago in the widely popular AmeriCorps program. It should learn from that lesson.

5. Mandate an Interest Rate Cut for Direct Loans, and Expressly Authorize an Interest Rate Cut for Federal Family Education Loans.

As regular readers of Higher Ed Watch know, there are two delivery mechanisms for federal student loans: (i) through the William D. Ford Direct Loan program, and (ii) through the Sallie Mae-dominated, Federal Family Education Loan (FFEL) program. The banks vigorously dispute it, but a series of government studies confirm that the Direct Loan program is vastly cheaper for taxpayers.

If Congress cut only Direct Loan interest rates, two things would happen. One, FFEL lenders would voluntarily cut interest rates below the 6.8% statutory maximum (as private MyRichUncle already has begun to do), and two, colleges would switch to the Direct Loan program, thereby generating taxpayer savings (as similiarly proposed by Congressmen Miller (D-CA) and Petri (R-WI) and Senators Kennedy (D-MA) and Smith (R-OR) in their Student Aid Reward Act).

Any of these five cost-trimming options or a combination thereof is possible. But juicier questions remain. Which of the multiple student loan inefficiencies will Congress tackle to pay for its student loan borrower interest rate cut? Will it only look to cut lender subsidies in seeking to offset increased spending on borrower benefits? Or will it reach beyond the student loan program for offsets?

And just how does cutting borrower interest rates serve the goals of either the Bush Administration or Congressional Republicans? Do either need to buy into a plan? Do either see a political opportunity?

One of them should. Guess which. And check back to higheredwatch.org for more later on how one of the two might take advantage.