Why Gov't Doesn't Need to Raise Student Loan Rates

I worked in Manhattan many years ago—at a time when 3-Card Monte was the hot ticket on the streets. As good as you thought you were at eyeballing the elusive ace that danced from palm to palm, you weren’t. And as much money as you expected to win, you walked away with that much less.

I’m reminded of this street scam as I listen to the debate over the Direct Subsidized Stafford Loan rate that’s set to expire in July. According to the news feeds, extending the 3.4% interest rate would cost taxpayers $6 billion per year. On the other hand, allowing it to expire will shift that cost to the students who are counting on the support.

But will the feds actually lose $6 billion for every year that the subsidized program’s reduced rate is in effect, or will the government just be making a little less profit?

The truth is the ace that’s shuffling back and forth on the card table. Slow down the action and you just might be able to catch it.

Banks, finance companies and even the government (when it operates as a lender) make money by borrowing it from one group and lending it to another—but not before marking it up to cover costs and a desired level of profitability. This markup is referred to as “spread.” It represents the difference between what a lender charges to its customers (“yield”) and the price of the money that it borrows to make the loan (“rate”).

Behind the scenes, rates are indexed to a given loan’s “half-life.” At the risk of oversimplification, half-life is roughly the duration of a loan divided by 2. So a fully amortizing 10-year loan has a 5-year half-life and a 14-year loan has a 7-year half-life. That 7-year half-life is a reasonable proxy for the standard government student loan program that spans 10 years of repayment after 4 years of borrowing (which occurs while the student is in school).

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With that in mind, take a look at the Markets tab on Bloomberg.com and focus on the 10-Year U.S. Treasury rate. That’s right, it’s just over 1%. So each incrementally borrowed dollar that’s needed to fund the loans the government is making today—subsidized and unsubsidized alike— costs just over 1%. But that’s not all there is to it.

The government incurs unique costs for the subsidized program because it’s paying the interest on the money needy students are borrowing while they’re in school. Assuming the annual loan limits that are detailed on the Federal Student Aid site, this program feature costs the government approximately one-half of 1% over the life of the loans it gives. That means instead of 3.4%, the government’s yield on these loans is actually 2.9%, before the expenses described below.

The government incurs administrative costs to service its loans for as long as they’re on its books. These costs cover accounting, record keeping and reporting; collections-related activities, such as for delinquent payments and restructures; and customer service-related activities, including payment processing and data modifications. In a loan portfolio the size of the government’s, it would shock me if these costs would diminish spread by more than 1% over average duration. That means instead of the 2.9% yield that I calculated above, the government is actually realizing 1.9%—still more than its 1% cost.

As for the rest of the expenses associated with operating this program, just as it is with other finance companies (including the ones I’ve owned and run) I’m going to assume that the 1% fee the government charges upfront for the loans it originates is sufficient to offset what it costs to process the paperwork. I’m also going to assume that the late payment fees it charges are sufficient to offset the financial cost of managing delinquencies.

So when you put all the pieces together, it appears that the government is yielding a little less than a 1% interest rate spread on the loans that it makes under the subsidized program and a little less than a 1.5% spread on those under the unsubsidized program, which inspires me to ask:

If higher education is in the nation’s best interest and if the government has the ability to lend money to its citizen students at an exceedingly affordable price that more than covers its cost, then why are we arguing?

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

Image: ZioDave, via Flickr