Education

The Positive Effect of using a Market-Based Value System for Student Loans

With the looming threat of interest rates doubling on future subsidized Stafford loans (a loan where the federal government pays the interest during the student’s college tenure) from its current 3.4% to 6.8% has resulted in a debate on how interest rates on federally financed loans should be determined. With the expiration of a one year-solution that kept the interest rates at 3.4% on July 1, 2013, Congress members from both parties are looking at long-term solutions to develop future interest rates.

One proposed solution is the continuation of the fixed interest rate system where Congress gets the ability to set the interest rate. This has produced a fixed 6.8% interest rate on unsubsidized loans (a loan where interest accumulates while the student is enrolled in college) and a fixed 7.9% interest rate on PLUS loans. The benefit of this system is that students know that their interest rate will not fluctuate, allowing them to calculate the long-term debt amount and come up with a budgeting plan for repaying their loans.

However, the major downside of having a fixed interest rate system is that interest rates remain consistent during periods of economic recession, which this country experienced a few years ago. As a result, college students are finding themselves accumulating huge amounts of debt, as they take out federal loans with high interest rates, to pay for the rising college costs. To offer future college students a way to accumulate less debt after graduating from college, Chairman of the House Education and the Workforce Committee, John Kline (R-MN) offered the solution of linking federal student loans to a market based fixed rate (commonly referred to as a variable rate system). In a recent statement, Kline and fellow Republican colleagues said they are working toward a long-term solution that better aligns interest rates with the free market, which would produce interests rates on federal student loans around 3%.

Adjusting federal student rates to the market allows loans to mimic the economic trends, and when tough economic times are present, the Federal Reserve keeps interest rates at a low level. Lower interest rates help households and businesses finance new spending and help support the prices of many other assets. As a result, Congressman Kline was correct when he noted that if federal loans were linked directly to a market based system students would be currently paying close to 3% interest rates on their federal student loans.

Agreeing with Congressman Kline, the National Association of Student Financial Aid Administrators stated that the data revealed that had the federal government stayed with a variable interest rate in 2006, all student borrowers in the Stafford and PLUS loan programs would actually have fared better than they have under the fixed interest rates of the last six years. To help elaborate on their statement they provided the following info graphic that illustrates that the years following the 2008 economic recession saw huge decreases in the interest rate, while under the market based system the rates have remained under 3%.

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The Congressional Budget Office (CBO) has supported using a fair value (a similar term for valuable rate) system when it comes to measuring future interest costs of loan programs, like federal student loans. The reason being that a fair value system provides a more comprehensive measure of federal costs and are better at recognizing market risks. As a result, Congress should look into using a fair value or market-based system to calculate the designated interest rate for their federal student loan programs. Using a market-based value system encourages more students to apply, as they know the amount of cumulative debt after they graduate, would be significantly less due to the lower interest rates. Also, it encourages more students, especially those with unsubsidized and PLUS loans, to complete their education for the same reason; they would owe considerably less due to the lower interest rates.

With the federal government playing the main role in helping students pay for college, the consequence has been that the government is shouldering a trillion dollars of unpaid student loans. As a result, it makes sense for the federal government to move in the direction of linking their federal loans to a market based system. This would help secure a long-term solution to what Congress should do with interest rates in the higher education system and thereby allow Congress to work on measures that helps lower the price of college tuition, allowing better access for a larger portion of American students.

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