The interest rate on a popular type of student loan is about to double on July 1, which has Democrats and Republicans scrambling to come up with some sort of bill that will soften the punch for American families—and possibly score political points.
Last week, the House approved a Republican proposal to peg student loan rates to the yield of 10-year Treasuries. At current yields, that means a 4.5% rate, which is lower than the fixed rate Congress established for most types of loans. President Obama has also proposed tying loan rates to the return on Treasury bills, though at lower levels than the House proposed and with borrowing costs staying the same for the life of the loan rather than fluctuating along with T-bill yields. Senate Democrats would like to push the July 1 deadline back another couple of years.
Indexing student loan rates to the government’s borrowing costs seems like a good idea, but anything that would make it cheaper for Americans to take on debt to finance college isn’t, for two reasons. First, student loans are likely feeding—or will soon start to feed—the federal deficit. Second, they’re also likely weighing on economic growth.
Student loans and the federal deficit
In 2004 U.S. households owed $260 billions in student loans, according to data from the Federal Reserve Bank of New York. In the first quarter of this year, that number was just shy of $1 trillion. It’s a staggering jump and it reflects two things: tuition costs have ballooned, especially at cash-strapped public institutions, and larger-than-normal percentages of Americans have been going to, or staying in, school in an attempt to improve their chances in the job market or wait out the tough times. Student loans were the only form of consumer debt that has kept growing through the recession.
Now, officially, federal student loans (which constitute the vast majority of such loans in the U.S.) are turning a profit. According to the latest figures from the Congressional Budget Office, the government is on track (pdf) to make between 14 and 64 cents, depending on the type of loan, for every dollar it lends out in fiscal 2013.
The official figures, though, are likely painting too rosy a picture (a big hat tip here goes to the Washington Post‘s Dylan Matthews). First of all, the the government seems to be overestimating the value of the money it expects to get back. By law, the CBO has to use a bizarre accounting method, mandated by Congress, which the Office believes understates the discounting rate on future cash inflows. Using the official way to do the math, the CBO warned in 2012, this year’s student loans and guarantees would appear to add $45 billion to the federal budget over the course of their life time. Using private sector accounting practices, though, that surplus turns out to be an $11 billion deficit.
Second, there are concerns that the government is also way too optimistic about how much money it will get back. Official estimates of whether student loans are a money maker or loser are based on assumptions about expected default rates for every batch of loans the government services every year. But those default expectations seem awfully low, according to the private-sector pros who work in the student loan business. Those forecasts are based on the Department of Education’s “cohort-default rate,” which, until recently, measured only the percentage of borrowers who defaulted in the first two years of payments. But that captures “only a sliver” of the actual defaults, according to an investigation by the Chronicle of Higher Education. New DOE numbers that extend the observation time-frame to three-years found that borrowers who started repaying their federal student loans in 2008 and 2009 had defaulted rates above 13%. Longer-term estimates are probably even worse: “one in every five government loans that entered repayment in 1995 has gone into default,” according to the Chronicle.
Student loans and economic growth
Student loans, some worry, are also starting to become a problem to economic growth. Debt-burned young families are likely weighing on consumer demand, which is still about 70% of U.S. GDP. Also, owing tens of thousands of dollars to the government does not entice, say, banks reviewing a new mortgage application. Coupled with long spells of unemployment, student debt is likely a drag on housing demand, despite rock-bottom interest rates and the Fed’s ultra-stimulative monetary policy.
Rather than subsidize borrowing, the government should make education more affordable: reform public schools so that they cost less and become better at equipping students with the skills that will land them a decent-paying job.
Sadly, that’s no short-term fix.
Erica Alini is a California-based reporter and a regular contributor to CanadianBusiness.com, where she covers the U.S. economy. Follow her on Twitter: @ealini.