This week everyone has been talking about student loans. The Obama administration announced some minor changes to the Direct Loan program. Separately, the House Education and Workforce Committee held a hearing to examine the program’s performance since Congress ended the bank-based guaranteed loan program last year. At the same time, some “Occupy Wall Street” protestors have been demanding relief from student loans. With all this attention on federal student loans, the direct-loans-are-profitable-for-the-government argument has been out in full force.
For example, at the House hearing Rep. John Kline (R-MN) said an interest rate of “6.8 percent when the federal government is borrowing at less than 1 percent can create a pretty big slush fund.” Democrats on the committee agreed with Kline that the government is earning money off of the program but argued lawmakers should consider lowering the interest rate that students pay to no more than what it cost the government to borrow and pay for loan defaults.
Generally, liberals, student advocates, and lobbyists for colleges say that Direct Loan profits suggest that the government is “overcharging students.” To conservatives and student loan companies, Direct Loan profits mean the government is competing with private businesses in providing a for-profit service.
Those would all be valid arguments except for the fact that the Direct Loan program doesn’t make money and it isn’t profitable.
The Direct Loan program issues about $100 billion in new student loans each year with over $500 billion in loans currently outstanding. The program charges undergraduates fixed interest rates between 3.4 percent and 6.8 percent. Graduate students get the same rates, but can borrow additional amounts at 7.9 percent interest rates under the Grad PLUS program. All students qualify for at least some type of loan regardless of their financial need. Repayment plans can be as long as 30 years and borrowers experiencing “economic hardship” can postpone payments for up to three years under deferment and forbearance policies, or can repay under income-based repayment plans. The government also forgives loans under a number of circumstances.
It’s common knowledge that banks make money by borrowing at low interest rates and making loans at higher rates. In the most basic sense that is a fair characterization. Many people therefore assume that Direct Loans are profitable for the government because the fixed interest rates borrowers pay are twice as high (or more) as what it costs the government to borrow.
But if the profitability of the loans is simply equal to the difference between these two interest rates, why don’t private banks make student loans at the same terms as the government? They can borrow at low rates too.
Take a look at the interest rate banks pay on savings accounts. It’s less than a third of a percent. A ten-year certificate of deposit pays 2.5 percent interest. Those rates are pretty close to U.S. Treasury rates, and they should be – bank deposits are insured by the federal government. They are certainly lower than the interest rate the government charges on student loans. But you won’t see your local non-profit credit union offering terms as good as a federal Direct Loan. That is because banks believe making loans at those interest rates and with those types of repayment plans is too risky relative to what the bank can expect to get in return. In other words, private banks are not willing to take on the risk associated with these loans at such low interest rates.
Of course, there are far more technical and complicated ways to explain why Direct Loans don’t make money, but we will leave those for another time. For now, take it as proof that not even the most efficient, most profitable banks in the country make loans as generous as those in the Direct Loan program because it is a money-losing endeavor.
It’s not bad, however, that the loans don’t make money. They aren’t supposed to. In fact, the government’s loss on the loans serves as a subsidy for the student who borrows to pay for school. According to a 2010 Congressional Budget Office study (page 10), the typical student gets a 12 percent subsidy on his federal Direct Loan. Put another way, the borrower receives a government benefit worth 12 percent of the amount he borrows. A $5,000 loan, therefore, provides a $600 government benefit to the student.
Regardless of these facts, any debate about federal student loans will inevitably be based on the false premise that the loans are profitable for the government. When the interest rate on subsidized Stafford loans jumps from 3.4 percent to 6.8 percent next school year, you can be sure there will be cries of usury. And as the Obama administration makes the case that the incentives it offers students to switch their loans over to the Direct Loan program save money overall, you can be sure some lawmakers will claim all of those savings come from profits earned off of students. Neither argument is true.