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Students take hit unless Congress acts

San Francisco Chronicle on March 14, 2013
By Kathleen Pender

Unless Congress acts, the interest rate on new federally subsidized Stafford student loans taken out after June 30 will revert to 6.8 percent – the same rate charged on unsubsidized Stafford loans – from 3.4 percent.

The discounted rate for subsidized loans, which go to lower-income families, was supposed to expire in June 2012. But lawmakers put on their can-kicking boots and postponed it for one year.

Now, rather than extending it again or letting it expire, some financial aid experts want Congress to overhaul the rate-setting process for all government-guaranteed college loans. In a hearing Wednesday before the House Education and the Workforce Committee, several urged lawmakers to return to a market-based approach.

Before 2006, Stafford loans for students and Plus loans for parents were similar to adjustable rate mortgages. The rate changed once a year; it was set at a certain margin above the rate on three-month Treasury bills.

However, students also had the option of locking in a rate by converting their loan or loans into a fixed-rate consolidation loan. In 2005, students could lock in Stafford loan rates as low as 2.875 percent.

Starting in July 2006, partly at the behest of student groups who wanted more certainty in their loan payments, the government began charging a fixed rate of 6.8 percent on all new Stafford loans and 7.9 percent on Plus loans, which also became available to graduate students.

Since then, rates on most other loans have fallen, in some cases dramatically. The average rate on a 30-year fixed- rate mortgage has dropped to 3.5 percent from (coincidentally) 6.8 percent, according to Freddie Mac data.

But the interest rate on Plus loans and unsubsidized Stafford and Plus has not budged.

If Congress had not changed its rate-setting formula in 2006, interest rates today would be about 2.4 percent on Stafford loans and 3.2 percent on Plus loans, although it’s unlikely lawmakers would have permitted them to get that low.

Subsidized discount

In 2007, Congress passed a law that gradually reduced the rate on subsidized Stafford loans over four years to 3.4 percent, but it was supposed to jump back to 6.8 percent last July.

This temporary discount was supposed to help low-income students, but it didn’t really affect their access to college because borrowers don’t have to make payments on Stafford loans while they are in school. They don’t even owe interest on subsidized loans while they are in school; the government pays it. On unsubsidized loans, students owe interest while they are in school, but they can add it to their loan balance and begin paying it after they leave school.

About half of the students with subsidized loans also have unsubsidized loans at the higher rate, said Justin Draeger, chief executive of the National Association of Student Financial Aid Administrators.

He says the current rate-setting structure is “out of step” with market rates.

“Students and parents often question why federal student loan interest rates are higher than nearly all other installment loans, particularly for families with good credit. And the truth is, there is no good, reasonable answer to that question,” Draeger wrote in testimony prepared for Wednesday’s hearing.

His association advocates returning to a variable interest rate, where the rate is based on the government’s cost of capital, the cost of loan servicing and counseling, and future risk.

One loan for all?

Jason Delisle, director of the nonpartisan New America Foundation‘s federal education budget project, says the whole complicated federal student loan program should be replaced with a single loan available to all undergraduate and graduate students regardless of income.

The rate would change once a year, but once a student takes a loan out at that rate it would remain fixed for the life of that loan. The rate would be pegged at 3 percentage points above the 10-year Treasury rate, which is a better benchmark for fixed-rate loans than 3-month T-bills.

“My scheme would give us, for the upcoming year, a rate of 4.9 percent for all undergrads and grad students,” he says.

If a year from now that rate is 5.9 percent, students would pay 5.9 percent on new loans, but continue paying 4.9 percent on loans taken out the previous year.

He would eliminate the interest subsidies for students coming from low-income families. Instead, he would move subsidies to the back end, where they could help any student having trouble repaying a loan.

One way is to put all borrowers into an income-based repayment program where monthly payments are a percentage of disposable income. He would forgive any balance remaining after 20 years, or after 25 years if they borrowed more than $45,000.

The federal loan program already offers income-based repayment on Stafford and graduate Plus loans, but only to borrowers with very large debt relative to income. The current program, he says, encourages graduate and professional students to borrow enormous sums because they know that anything above a certain amount will be forgiven. His plan would create a disincentive to borrow more than $45,000.

Some student groups, such as the Young Invincibles, also want a hybrid fixed-adjustable loan, but with an interest rate cap to protect borrowers if rates skyrocket.

The Institute for College Access & Success also favors a hybrid loan, but with a guarantee that if market rates plummet by a certain amount, the borrower’s rate would come down.

Delisle opposes any limit on the upside or downside – because it would pose a risk to taxpayers and be just as arbitrary as the 6.8 percent rate on Stafford loans.

Kathleen Pender is a San Francisco Chronicle columnist. Net Worth runs Tuesdays, Thursdays and Sundays. E-mail: Blog: Twitter: @kathpender