Congress and the president need a more rational way to set interest rates on federal student loans. The 6.8 percent rate on the most widely-available type of loan was set in 2001 and based on what student advocates and lawmakers thought sounded good then. Years later, lawmakers lowered the rate to 3.4 percent, but only for some undergraduates, and only on a portion of their loans, and only for loans made during the 2011 school year. President Obama wanted that policy extended for just one year*, *and Congress obliged. Rather than extend that policy further, lawmakers should consider a comprehensive and permanent interest rate fix – one that applies to all new federal student loans.

An approach outlined in the New America Foundation paper released today, *Rebalancing Resources and Incentives in Federal Student Aid*, would peg fixed rates on *all *new federal student loans to the interest rate on 10-year U.S. Treasury notes in the year the loans are issued, plus 3.0 percentage points. That formula would set rates low enough to provide a below-market rate to students, but still offset some of the cost of the loan program. Loans issued this year would carry an interest rate of 4.9 percent (as of today), which would actually cut borrowers’ loan payments further than an extension of the 3.4 percent rate (this is tricky, but the math is here). What’s more, the policy is budget-neutral over a 10-year window.

One consequence of setting interest rates based on, well, interest rates, is that rates can go up. Student aid advocates and policymakers worry that this could make loans unaffordable for borrowers. They suggest capping the rate. Unfortunately, a cap would be extremely costly, not to mention arbitrary. A Congressional Budget Office estimate shows that a formula to set variable interest rates on federal student loans, capped at 6.8 percent, would cost $200 billion over the next 10 years. That is not a typo – $200 billion.

Those who argue for a cap may not realize that the federal student loan program already includes a built-in interest rate cap. It’s called Income-Based Repayment (IBR). This plan acts like an interest rate cap because borrowers don’t make payments based on the nominal interest rate on the loan or even on the loan balance. Monthly payments are based on income (10 percent of Adjusted Gross Income [AGI] minus a cost-of-living exemption), and the loan term is fixed at 10 or 20 years through loan forgiveness. To be sure, a higher interest rate could cause a borrower to pay *longer*, but the 10-year and 20-year loan forgiveness provisions reduce that risk substantially – the loan is forgiven before the higher interest rate matters.

To illustrate this effect, we ran a number of scenarios through the New America Foundation IBR calculator. Consider someone with $45,000 in debt from undergraduate and graduate studies who works in the government/non-profit sector and earns a starting salary of $38,000 (AGI of $34,200) with a four percent annual raise. At an interest rate of 4.9 percent, she pays a total of $22,281 on her loans over 10 years, and then the remaining balance is forgiven under Public Service Loan Forgiveness. At an interest rate of 12 percent she still pays $22,281 and the remaining balance is forgiven. Even if her interest rate were 0.0 percent, her total payments would still be $22,281.

What if the same person worked in the for-profit sector and therefore qualifies for loan forgiveness after 20 years of payments instead of 10? At an interest rate of 4.9 percent, her total payments over 20 years are $58,998 and she has some remaining debt forgiven. Increase her interest rate to 12 percent and her total payments are still $58,998. IBR has capped her payments – and the interest rate on her loan – because her income isn’t high enough for the interest rate to matter.

As another example, consider a borrower with undergraduate debt of $28,000 working in the for-profit sector with a starting income of $29,000 (AGI of $26,100) and an annual increase of three percent. She would pay $27,228 on her loans over 20 years at an interest rate of 2 percent, 5 percent, or 25 percent. Her monthly payments over that time would be no higher or lower under any of those interest rates.

Under IBR, only borrowers with higher incomes would be affected by higher interest rates. But the program still provides a cap even for these borrowers, albeit a higher cap. Moreover, monthly payments are still based on income – only the length of payment is affected by the interest rate. And high-income borrowers who work for the government or non-profit organizations fare even better because they qualify for 10-year loan forgiveness.

Imagine a borrower with $40,000 in debt and a starting salary of $50,000 (AGI $45,000) who receives an annual raise of four percent. If she works for a non-profit employer, the interest rate on her loan is irrelevant. She’ll pay $35,247 before her remaining debt is forgiven after 10 years of payments whether the interest rate is 2 percent, 6 percent or 12 percent. However, if she works for a for-profit employer, her higher income means she’ll pay for longer if the interest rate is higher. But if the rate is 8 percent or higher, she won’t pay all of the extra costs. Instead, she will have much of it forgiven once she reaches 20 years of payments.

All of these examples illustrate how IBR works like an interest rate cap for borrowers with lower incomes or those who work in government/non-profit jobs. Student aid advocates and policymakers must therefore ask why an arbitrary interest rate cap is an essential part of any interest rate formula for federal student loans. Is the goal to limit payments *regardless* of a borrower’s income and *regardless* of interest rates in the market? If so, in a high-interest rate economy, a cap will provide low interest rates to individuals earning high incomes. Probably not the best use of scarce financial aid dollars.

*Readers can download the New America Foundation IBR calculator here and view the above examples by entering in debt level, interest rate and borrower income. Readers should also try their own examples. The New America Foundation also published a paper last year on the effects of recent changes to IBR. *