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Student Loan Interest Rate Discussions 2013

Student Loan Interest Rate Discussions 2013

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Published by Barmak Nassirian
Policy Options on the Rate Formula
Policy Options on the Rate Formula

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Categories:Types, Research
Published by: Barmak Nassirian on Jun 20, 2013
Copyright:Attribution Non-commercial

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05/02/2014

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MEMO
To:Interested ColleaguesFrom:Barmak NassirianSubject:Interest Rate DiscussionsDate:June 19, 2013As discussions about the rate formula enter final stages, I thought I'd share some additional commentson the trade-offs involved with the various policy options that might be in play. I'll offer theseobservations in no particular order, but should point out that beyond the direct impact of each variable,there are significant interactive effects associated with the combination of various options.1-This is the worst possible time for changing the formula from a fixed numerical statutory rate toan index-based rate,
regardless of which index is used 
. This is because interest rates are at historicallows, and given the mandate that any rate change be budget-neutral, any conversion to a formula basedon a market-based index would result in a much higher add-on margin than would be needed if interestrates were at more historically typical rates. (Any formula that is budget-neutral within the five- andten-year CBO budget-scoring windows would in effect overcharge borrowers in the out years, probably by about 2 percent if rates bounce back to their historical levels.)2-In light of the first observation above, a permanent legislative change is ill-advised because itwould move the scoring baseline so high that a future correction would carry unaffordable paygo costson the budget. It would be much wiser to negotiate a temporary five-year policy that would revert back to current law than to “fix” the issue with an exorbitantly high, but effectively immutable, rate for  perpetuity.3-The Administration's criticism of variable rates notwithstanding, formulas that lock the rate for the life of the loan are bound to treat different cohorts of borrowers in a random and nonsensicallyunfair manner. Locking rates based on market conditions that prevail at the time the loan is taken outwould base the true cost of borrowing on luck of the draw, and reward those who happen to borrowwhen rates are low while punishing cohorts who borrow when rates might be anomalously high. This becomes a real problem in student lending, which—unlike mortgages—does not provide refinancingoptions for those caught in high interest rate loans. In addition, locking rate for the term of these loansdoes not provide the the lender (i.e., the federal government) the benefit of asset-liability matching,since the federal government does not fund direct loans through a dedicated Treasury auction. Avariable rate with an annual reset would be a much more economically logical mechanism of sharingthe interest-rate risk between borrowers and the federal government, treating all cohorts of borrowersconsistently, and synchronizing the repayment burden with economic conditions that prevail in realtime. Those who are skittish about the uncertainties associated with variable rates should recall thatwe've had millions of borrowers (the 1993-2006 cohorts) in variable-rate loans that reset every July 1,with no adverse impact due to the inability to disclose the exact rate to prospective borrowers. Inaddition, borrowers from these cohorts who are still in repayment have derived real benefits from the plummeting rates, like a 2.5% rate under today's circumstances.Should a locked rate prove an absolute non-negotiable, serious thought should be given to additional borrower protections like a rate cap or a step-down rate reset that would allow anomalously high ratesto be capped or reset once high-rate circumstances pass. Neither of these would be absolutely necessaryin a variable rate system, since unusually high rates would, by definition, be temporary.

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