Lower-Cost Student Loans? Not Really.

Auctions of U.S. Treasury notes and bonds don’t usually attract a lot of attention unless we are in the midst of tumultuous times or when the lending rates for a pretty important loan program are indexed to one of these.

At nearly $1 trillion and counting, the Federal Direct Student Loan program deserves all the attention it can get.

So when the Treasury Department sold a fresh batch of 10-year notes last week at a yield that turned out to be more than a third of a percentage point lower than it was at in the same period in 2014, the headlines touted the corresponding decline in student-loan rates as welcome savings for student borrowers. I suppose that’s true if one were to ignore the pace at which tuition prices have been increasing each year and the large number of students who fail to complete their studies because they can no longer afford enrollment. (Nearly 50% of all students don’t complete their degree.)

How Much Does the Government Profit From These Loans?

The truth is that although the cost of financing higher education has declined because of favorable market conditions—a sword that most people realize cuts both ways—the politically contrived methodology for setting these interest rates in the first place continues to result in enormous profits for the federal government, given the way it borrows to support this activity.

Take, for example, the new 4.29% rate for Federal Direct undergraduate loans. It’s based on the recent 2.24% yield-at-auction for the 10-year Treasury note plus a 2.05% markup. Perhaps lawmakers chose the 10-year T-note because it coincides with the 10-year repayment term for these loans. If so, someone should let them know that that’s not how structured finance works in real life.

Loans that fully amortize over time are typically bankrolled at rates that approximate their so-called half-life: roughly 5 years for a 10-year loan. That means the 5-year T-note should be the basis for pricing these loans, rather than the 10-year.

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What does that mean? The difference between the higher-rate 10-year and lower-rate 5-year notes was 0.68% at the time of this writing, which doesn’t sound like much until you translate that into present value profit dollars. Doing so, that 0.68% becomes worth 3.4% in cash profits if these were paid upfront. That’s in addition to the aforementioned 2.05% markup, which Congress also authorized and is worth an additional 10.25% of front-ended profit. Add to that the 1% cash fee that the government charges on its undergrad and grad/professional loans on day one and the feds have a respectable 14.65% payday coming its way: nearly 10 cents on every borrowed dollar.

But wait, there’s more.

As it turns out, not only isn’t the government borrowing 10-year money to fund this program it’s not borrowing less expensive 5-year money, either. In fact, past reports indicate that the Education Department is actually financing its programs with dirt-cheap, very short-term debt: currently priced at 0.01% interest. That means there’s an extra 2.23% of interest-rate spread at play (2.24% minus 0.01%), which translates into an additional 11.15% of present value profit.

Everything taken into account, the ED’s program delivers nearly 26 cents in profit on every borrowed dollar. And that’s just for undergraduate loans. The same calculation, when applied to the graduate and professional program, results in a 30.15% profit, and a whopping 38.15% for parent PLUS loans—all of which comes at the expense of student borrowers and the parents who support them.

Is There a Better Approach?

It’s important to note that the “government” in the form of the ED didn’t devise this pricing mechanism on its own. The folks we elected to the House and Senate did two summers ago.

There are two ways to deal with this outrage. One would be to hammer our representatives for a more economically reasonable and rational rate structure. The other would be to use what’s already in place to the students’ advantage.

If lawmakers insist on maintaining as the basis for these programs rates that more properly support 20-year payment plans, they should grant to all students the right to refinance their existing debts for the same 20 years at the rates that are currently in place. Not only would their monthly payments become more manageable, but doing so could also lower the rate of payment delinquency and default, and diminish the need for additional relief as well.

Oh, and one more thing.

Since Congress appears to be OK with a program that generates profits almost as high as those that result from long-term credit card debt, how about making student debts comparably eligible for discharge in bankruptcy? That’ll go a long way to providing all lenders and loan servicers with a really good reason to deal more forthrightly with their financially distressed borrowers.

This story is an Op/Ed contribution to Credit.com and does not necessarily represent the views of the company or its affiliates.