Next week, the House Education and the Workforce Committee will begin discussions about the interest rate on federal student loans, which is set to double on July 1. If this sounds like “déjà vu all over again,” that’s because it is.
Around this time last year, Congress grappled with whether to allow interest rates to double from 3.4 percent to 6.8 percent and agreed to a one-year extension of the artificially low rate. It’s a political process, not a process of reasoned policymaking informed by the types of factors private lenders must take into account.
What should Congress do about the looming interest rate hike? As long as the federal government is in the student loan business, fair-value accounting practices should be employed.
The fact that private lenders aren’t scrambling to offer loans to any student who wants one at a 3.4 percent interest rate is one indication that the current rate might be too low. Private lenders take into account factors such as how likely a student will be to pay back the loan, the student’s major and credit history, whether the student has a co-signer, and the type and quality of university the student attends. The federal government takes none of those factors into account, leaving it to the taxpayers to bear the burden of risky loans if a student later defaults.
Today, the federal government’s accounting practices fail to account for this market risk, and as a result, likely understate the cost of student loans to taxpayers. It is likely that federal student loans cost the government money, as opposed to making money, as is currently claimed.
In contrast, fair-value accounting—which is preferred by the Congressional Budget Office—would apply a much higher discount rate when determining the revenue from student loan repayments to incorporate market risk. As Congress again considers whether to allow student loan interest rates to double, bringing them more in line with market rates, policymakers should, at a minimum, insist on moving to a system of fair-value accounting so that taxpayers are fully aware of the cost of the student loan program.
Next week, the House Education and the Workforce Committee will consider the Smarter Solutions for Students Act, which would peg interest rates on federal Stafford loans to the high-yield 10-year Treasury note plus 2.5 percent. For Parent Plus loans, the proposal pegs the interest rate to the high-yield 10-year Treasury note plus 4.5 percent. Both interest rates would be capped, at 8.5 percent and 10.5 percent, respectively.
While the proposal would move toward a less political means of establishing interest rates, any proposal advanced in Congress should employ fair-value accounting to determine the cost of the student loan program. Those estimates should be used to adjust interest rates accordingly to ensure there is no subsidy for the loan program moving forward. This reform should enjoy bipartisan support.