Last week, Senator Elizabeth Warren (D-Mass) unveiled her first piece of legislation on the Senate floor — a proposal to allow students to borrow at the same rates as banks. While this move galvanizes the populist movement, the economics behind it does not quite add up.
The interest rate on direct subsidized loans for undergrads is currently 3.4 percent, but it is set to double to 6.8 percent in July. Warren proposes lowering this interest rate to 0.75 percent, the Federal Reserve discount rate at which banks borrow overnight through the primary credit program.
The rhetoric behind the idea is strong: why shouldn’t students get the same deal that banks do? But that’s about all it is — rhetoric. This is because a student loan is not at all like an overnight loan. Interest rates are determined by time horizon (how long it will take to repay) and creditworthiness (how likely someone is to repay), and student loans and overnight loans are very different across both of those dimensions.
Time horizon: 10+ years vs. overnight
First, the two types of borrowing are across very different time horizons. A student loan typically takes more than ten years to pay back in full. For example, President Obama announced last year that he only finished paying off his $60,000 in student loans in 2004, thirteen years after finishing law school. In contrast, an overnight loan is exactly what it sounds like. Through the primary credit program, depository institutions can borrow at 0.75 percent for overnight loans. They generally use these overnight loans to cover short-term balance sheet adjustments.
A more appropriate comparison would be the interest rate that the banks pay on long-term loans. For example, the U.S. government, which should receive the most favorable interest rates on its long-term loans, pays an average of 1.8 percent in interest on ten-year loans and almost 3 percent on 30-year loans.
Creditworthiness: Proof of enrollment vs. adequate capital standards
Second, the two types of borrowers have very different levels of creditworthiness. To be eligible for a federal student loan, you just need a Social Security number and proof of enrollment in an accredited institution. You cannot have a previous default on a prior federal student loan, but other than that, there are no credit checks or screening of your creditworthiness.
Banks who are eligible to borrow at the discount window, however, need to be “adequately or well capitalized,” a status that is designated and routinely reviewed by the Federal Reserve. Although some might argue that primary credit lending is still relatively lenient, given that it is administered on almost a “no questions asked” basis, access to primary credit is still restricted by capital standards, while access to student loans is not.
Still, many people complaint that interest rates on student loan debt are too high, and delinquency rates are on the rise. As a recent graduate with a lot of student debt myself, I certainly wish that the interest rates were lower. However, I acknowledge that I am in no way like a bank – I’m not going to pay back my debt tomorrow, and I have negative net worth at the moment.
So while Senator Warren’s proposal makes for good press, the economics of it just don’t make sense.