How Much Should Student Loans Cost?

Flickr/Christopher S. Penn

Are student loans moneymakers for the federal government? 

The debate whether the federal government should keep its interest rate for student loans at 3.4 percent rather than let it double to 6.8 percent on July 1 has focused almost exclusively on what the rate change might cost students. But while the impact on borrowers can be calculated, how does the potential rate change affect the government?

There is no quick take on the matter, though, because an old law makes reporting the cost of issuing a loan more of a legislative art than a fiscal fact.

Jason Delisle, a federal education spending expert at New America Foundation, a D.C.-based think–tank, says the answer depends on how Congress reports the cost of issuing federal student loans. Following the Federal Credit Reform Act of 1990, the accounting rules on reporting federal expenses for education loans changed, allowing the government to calculate the cost of these loans differently than private financial institutions do. Mainly, the government can report that the financial risk of borrowers defaulting on their loans costs less than it would for private lenders.

Because the government issues loans based on U.S. Treasury rates, which are cheaper than market rates, the risk of lending costs appears less for the government.

In policy circles, the rate at which private lenders have to set these loans—including the risks—is called “fair value.”

To some, that privilege means the government effectively makes a profit off of education loans; to others, it’s bad accounting that hides the real costs that result from lending based solely on need, not whether borrowers are credit-worthy enough to pay back these debts. If the budgeting understates the cost of the loan program, other subsidies are less likely to be affected as well.

“Congress has a budgetary incentive to expand loan programs rather than create grant programs or tax programs because the loan programs are treated so favorably by these budget rules,” says Delisle.

Indeed, in the Department of Education’s 2013 budget request to Congress, officials write the Direct Loan Program—which includes subsidized and unsubsidized Stafford Loans—was estimated in fiscal year 2011 to earn 13.91 percent on every dollar in loans issued, “thereby providing savings to the Federal Government.”

Meanwhile, the Congressional Budget Office, the fiscal scorekeeper for all federal bills, released an issue brief earlier this year advocating for a change in how it determines the deficit impact of federal loan programs, preferring to report the costs using the “fair value” model. It warned defaults on loans are paid for by issuing more Treasury notes, tax increases, or spending cuts. In 2010, the CBO calculated that using the “fair value” model, the government actually loses 13 percent on every Direct Loan dollar spent.

Mike Konczal, a fellow at the left-leaning Roosevelt Institute who specializes in finance, wrote in February the government can afford to undercut fair value loans because it has a very aggressive collections arm in the event loan holders default. Paying additional penalties, garnished wages, and loss of tax refunds are all ways the government can get its money back. For its 2013 budget request, the Department of Education calculated it will make money off of defaulted loans.

It’s not as if the government is being accused of poorly assessing risk, but some say its not fairly weighing the hit to the deficit bad loans might cause. For example Deborah Lucas and Marvin Phaup, researchers at Northwestern University and George Washington University who study loan costs, argue for the fair value estimate of issuing loans. Under their system, the government would calculate an extra cost to loans issued that would function as a safety net for the taxpayer. The Center for Budget Policy Priorities, a left-leaning policy group, criticizes the Lucas and Phaub argument because it believes they are asking the government to account for expenses it will never have to pay anyone.

Delisle, the New America Foundation analyst, notes there are a handful of caps on federal student loans that limit the government’s exposure to risk. For example, students can take out no more than $31,000 before they graduate, and there are limits on how much a student can take out in a single year.

Nor does he feel the government should start charging fair value prices, because the point of having a government program is to offer a subsidy.   Of course, the actual value of that subsidy—for students and the government—will likely always be a matter of debate.