Why Lower Interest Rates Alone Won't Fix the Student Loan Crisis

When Congress passed the Bipartisan Student Loan Certainty Act of 2013, interest rates were on the verge of doubling. Once the legislation was signed into law, however, rates fell, and the sponsoring politicians rushed to take credit for having solved a notorious problem for all time.

If only that were true.

Apart from the legislation’s absurdly contrived tiered-pricing methodology for loans to undergrads, grads and parents—which actually penalizes more creditworthy borrowers while contributing stunning levels of deficit-reducing profitability to the federal government (more on that in a moment)—there is the inconvenient issue of the accelerating rate of payment delinquencies and loan defaults that has taken place since.

I can think of four possible reasons for that: Demand for educated workers has significantly declined (it hasn’t), the troubled loans should not have been made in the first place (perhaps, but not to this degree), interest rates and fees are too high (yes, but not compared to other consumer-loan products), or the repayment term is too short (bingo!).

How the Government Profits From These Loans

Beginning with the matter of price, forget about how much money the government is raking in by funding high-rate, 10-year loans with low-rate, 3-month (or less) borrowings, because that scheme won’t continue too much longer. The Federal Reserve announced that it will begin tightening monetary policy very soon. Instead, consider how banks and other sophisticated lenders routinely finance fixed-rate loans with what is in effect “half-life” money.

For example, a 10-year loan would be funded with borrowing that is priced at the 5-year rate because—this gets a bit wonky—although the full principal balance is outstanding at the start of the loan, nothing will be due after the final payment is made. Therefore, it’s as if half of the loan’s value is outstanding at any given time during the term, hence the case for applying a 5-year funding rate.

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With that in mind, I began by taking a quick trip to the “Markets” tab on Bloomberg.com and noted that the government would have paid 1.48% if it were borrowing 5-year money on that day.

Then there is the cost for servicing the ensuing debt agreements. I recently perused the documentation for a securitization transaction that was collateralized by student loans. The servicer was paid slightly less than 1% of the declining payment balance over time. The interest-rate equivalent of that is 0.2% (a bit more wonkiness: the 1% is divided by the loan’s half-life—five years in this instance), and it happens to be more than enough to cover a typical loan servicing company’s costs.

The final element of the pricing equation is for anticipated losses due to borrowers’ delinquency or default. Setting aside the politically contrived argument that was made years ago for denying dischargeability in bankruptcy for student loans (a move that shields lenders from losses), education loans are uncollateralized, as are credit card obligations. As such, it would be reasonable to expect these to exhibit similar repayment characteristics.

So I took a look at the most recent Federal Reserve statistics on net charge-offs for all consumer loans (i.e., the percentage value of the loss a lender would sustain after exhausting its collections efforts), and found that credit card charge-offs are running at a 2.1% annual rate. But let’s use an overly conservative 5% loss rate for this example, just to be sure. The interest rate equivalent for that is 1%.

Borrowers Don’t Have to Lose Out

In the scenario I’ve just described, the government’s breakeven cost for providing 10-year financing would be 2.5%. And that’s without differentiating among undergrads, grads and parents. Frankly, there is no valid reason to do so. If anything, one would anticipate that grads and parents are more creditworthy than undergrads because they are typically older and more established in their careers. Yet, lawmakers decided the government should charge grads and parents more than it does undergrads.

Regardless, here’s what happens when a fairer rate is applied to these loans.

Taking undergraduate borrowers first, according to a study by the Institute for College Access and Success, the average outstanding student loan balance for new college graduates at the bachelor’s degree level is roughly $30,000. If all that were financed at the current Federal Direct rate of 4.29%, the monthly payment would be $307.89 for the 10-year duration of the loan.

Juxtapose that with a survey that was conducted by the National Association of Colleges and Employers. It found that the median starting salary for Class of 2014 graduates is approximately $45,000. As such, annualized loan payments of $307.89 per month represent 12.6% of median take-home pay (after taxes and benefits).

If the government’s loan rate were lowered to its estimated breakeven cost (2.5%)—as some lawmakers and presidential candidates advocate should be done—it would only lower the monthly payment amount by a paltry $25.

The story is similar for master’s degree-holders. Student-loan debt averages $58,000 for borrowers who can expect to earn a comparable amount in salary upon graduation. If all that were financed at the current Federal Direct rate of 5.84%, the monthly payment would be $639.27, or a whopping 20.3% of average take-home pay.

Repricing these loans at the governmental breakeven cost would save this group of debtors less than $100 per month.

Clearly, it will take more than lower interest rates to change the direction in which the payment performance on student loans is currently headed. The loans’ durations must also be extended if we want these loans to be fully repaid.

Given the average sizes of these debts and the typical borrower’s early-career earnings, the term that makes the most sense spans 20 years. As it happens, it’s also the fallback duration for the government’s own income-contingent programs. But that relief is being doled out on a onesy-twosy basis, eligibility is not universal, annual recertification is problematic and the interest rates typically remain unchanged.

Then, there is the matter of the government’s borrowing cost for this after-the-fact “fix.”

The proper way for the feds to fund a 20-year loan is with 10-year money, which, per Bloomberg.com in our continuing example, would run 2.15% in interest. Servicing costs add 0.1% and losses another 0.5% (both adjusted for the longer repayment term), for an estimated governmental break-even rate of 2.66%.

Although the interest rate is slightly higher in this scenario (because longer-duration debts typically command higher rates), not only is it significantly lower than what education-borrowers are currently being charged for new loans, but the extended repayment duration will have a substantially positive effect on debtors: The average payments for undergrads and grads would be chopped more or less in half, to the equivalent of a very manageable 6.5% of take-home pay for undergrads and 10.3% for grads.

There are no two ways about it: A loan portfolio that is as seriously troubled as this was incorrectly structured at its inception. Consequently, the only way to remedy that fundamental error is to recast it en masse. That means mustering the political courage to reduce the implicit interest rate to the government’s break-even cost in tandem with extending the repayment duration for current and future borrowers.

Only then could lawmakers legitimately claim to have addressed the problem of financing higher education “for all time,” and move on to the more profoundly important matter of reining in tuition prices.

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