The Student Loan Saga Ends?

After weeks of deliberation and two and a half weeks after a key deadline passed, we finally have a deal on student loans. A bipartisan group of Senators and the White House hashed out a deal to reform student loan interest rates, well after the 3.4 percent rate on subsidized Stafford loans had reverted to 6.8 percent on July 1. Importantly, the deal, if enacted, would handle the provisions both permanently and in a fiscally responsible way, reducing the deficit through 2023 by a modest $715 million. It is praiseworthy and should serve as a model for handling other temporary provisions in the budget.

The deal as expected links rates for subsidized Stafford loans, unsubsidized Stafford loans, GradPLUS loans, and parent loans to the ten-year Treasury bond rate. Both subsidized and unsubsidized loans for undergraduates would be set at the ten-year rate plus 2.05 percentage points with a cap of 8.25 percent. Unsubsidized loans for graduate students would be set at the ten-year rate plus 3.6 percentage points with a 9.5 percent cap. GradPLUS and parent loans would be set at the ten-year rate plus 4.6 percentage points with a 10.5 percent cap. In all cases, the rate would be fixed over the life of the loan. A press release from the Senators states that the rates will be 3.86 percent for undergraduates, 5.41 percent for unsubsidized grad student loans, and 6.41 percent for GradPLUS and parent loans.

So what could interest rates look like in the future? The graph below shows how interest rates would look if they followed CBO's latest economic projections. Note that the numbers aren't perfect, since the ten-year Treasury rate for student loans is determined by the last auction before June 1. CBO does not have that kind of detail in their economic projections, so we simply used the rate in the second quarter.

^{Source: CBO, CRFB}

Pegging the rate to the Treasury rate has a number of advantages. As the graph above shows, it will lower interest rates substantially in the early years. For 2013, the policy would reduce interest rates for about four fifths of all loans by 43 percent. The remaining loans will see an interest rate reduction of roughly 20 percent.

As interest rates go up, the effective subsidy from the government will remain roughly constant rather than fluctuating based on a constantly changing difference between actual interest rates in the economy and arbitrary nominal rates set by student loans. If interest rates stay low, so too will student loan rates. However, this approach also recognizes the importance of fiscal responsibility by ensuring interest rate increases don't impose additional costs on the taxpayer.

(Worth noting is the cap on student loan interest rates, which provides additional protections to students though also result in additional liability for the federal government.)

Importantly, this proposal -- reached on a bipartisan basis -- shows that Washington can indeed solve problems, and it shows how they should do so. While it is quite unfortunate that Congress did not act as they should have before the deadline, they also appear to have avoided falling into old traps of solving problems one year at a time. The easy solution would have been to simply extend current rates on subsidized loans for one more year rather than addressing these rates on a permanent basis. That they took the tougher but more responsible approach in this case suggests hope for addressing broader fiscal challenges. As CRFB President Maya MacGuineas said in our press release:

Instead of passing one-year patches and kicking the can further down the road, lawmakers need to work together to find solutions for the long term. Hopefully, Congress and the President will build on this experience to find agreement on a permanent solution for sequestration that puts the debt on a clear downward path relative to the economy.

Click here to read the press release.