Doubling of Student Loan Interest Rates Not What It Appears

After Congress failed to reach a compromise before the July 4th recess, student loans subsidized through the Federal Direct Stafford Loans program will see interest rates double from 3.4% to 6.8%. Pundits and the media have been reporting this as “Congress’s failure to act,” and a “catastrophic increase” on students. However, there are several reasons this “failure to act” is a good thing. 

A little background first. Normally, interest rates fluctuate just like every other price in the economy. But government backed student loans operate very differently. Since July 2006, the Federal Government began fixing interest rates at 6.8%, not allowing them to increase above that level regardless of the amount of loans. In 2007, Congress voted to bring the rate down to 3.4% over the course of four years, and later extended it in 2012 for another year. However, this only handles subsidized loans in the Stafford program, which account for a quarter of all federal loans. As well, the current debate only regards new loans, not existing ones, since they already have fixed rates. Thus, the issue at hand deals with, more or less, a rate increase on ¼ of all future loans. 

According to the Congressional Research Service, the difference between 6.8% and 3.4% is the equivalent of $6-$10 (depending on how much is barrowed) a month for a 10 year standard repayment plan. The cost increase then to a student is the difference of a couple beers or frappuccinos a month.  But extending the 3.4% rate will cost $41 billion to taxpayers over the next 10 years. 

As well, there are fundamental problems with fixing interest rates. Sure, we’d all love lower interest rates, but what are the consequences for the broader economy? By fixing the interest rate so low, it encourages over-borrowing by students. While this technically helps some students go to school, it makes tuition more expensive for everyone. It also gives colleges and universities less incentive to cut costs since more of the tab is being picked up by taxpayers. As Neal McCluskey, the associate director of Cato’s Center for Educational Freedom summarizes, “It both encourages students to demand things they otherwise wouldn’t — more expensive programs, lots of educationally superfluous amenities — and enables colleges to raise their prices, since cheap aid ensures that students can pay them.”

 In some sense, we are doing students a disservice. We are over encouraging individuals to seek college education, so they go to school, rack up debt, and can’t find jobs when they graduate. Student debt stands at a whopping $1 trillion nationally.  Half of 2012’s class of graduates ended up unemployed or underemployed.  Further, many people do not need degrees for the work they end up doing. The Center for College Affordability and Productivity released a report which showed that, “More than one-third of current working graduates are in jobs that do not require a degree, and the proportion appears to be rising rapidly,”  commenting, “we may have significantly ‘over invested’ public funds in colleges and universities.”  This trend will only continue in the future, as the Associated Press reported, “only three of the 30 occupations with the largest projected number of job openings by 2020 will require a bachelor’s degree or higher to fill the position.”  

In essence, the current program is arbitrarily encouraging students to pile on an enormous amount of debt with hardly any way to pay it off. Granted, employers prefer those with degrees over those who do not have one. But part of this, “credential inflation” would likely be reduced if the artificial demand for education was deflated. 

However, even letting rates double to 6.8% does not solve the problem. It is still a fixed rate. How can a few people in a boardroom meeting know the proper price that will coordinate the necessary supply of loans with the student demand?  What is magical about 3.4%? Nothing, it’s all totally arbitrary.  

Representative John Kline (R-Minn.) seems to agree: “The market is a much more reliable determiner of the true cost of capital than a bunch of us sitting around taking a guess.” Rep. Kline, however, sponsored the Republican “free market” solution that would tie interest rates to the yield of a 10-year Treasury bill plus 2.5%. While this is a slight improvement, it is hardly a free market solution. In fact, all this does is tie interest rates to T-bills, which are subject to much manipulation by the Federal Reserve; just another ‘bunch sitting around taking a guess’.

Congress needs to understand the serious side-effects of their policies. While they are well intentioned, they fail to realize their market tampering causes tuition and credential inflation, misguides students’ choices, and burdens taxpayers. The only true solution is market competition in the realm of student loans, not arbitrary numbers determined by Congress.