Student Loan Financing Reform

Student Loan Financing Reform


Student loan financing is continually increasing in volume. Budgetary accounting procedures are creating a discrepancy in budget projections.

The Fair Credit Reform Act (FCRA) of 1990 established procedures for calculating the cost of federal credit programs. This budgeting process determines whether federal programs are operating as positive or negative subsidies. The Direct Loan program, created by the Higher Education Amendments of 1992, as a pilot program and expanded by the Student Loan Reform Act of 1993, has operated since July 1, 1994. Under this program, the Federal Government provides the loan capital, post-secondary institutions are responsible for the loan origination, and servicing is handled by the Department of Education through private sector contractors. The Direct Loan program began operation in the academic year 1994-1995 with seven percent of overall loan volume; as of July 1, 2010, the program accounts for all new loan volume.

There are four types of loans that are available under the Direct Loan program, Unsubsidized Stafford, Subsidized Stafford, PLUS, and Consolidation. These can be used only to meet qualified educational expenses. A financial needs test, based on family income, is required for a student to receive a Subsidized Stafford Loan. Unsubsidized Stafford, PLUS, and Consolidation Loans are available to borrowers at all income levels. PLUS Loans are available to parents of dependent undergraduate students as well as to graduate and professional students. Consolidation Loans allow borrowers to combine their obligations from loans made under Title IV of the Higher Education Act into one loan, thereby eliminating multiple monthly payments during the repayment term. In 2013, Congress set interest rates on student loans to the 10-year Treasury note plus 2.05 percentage points for undergraduates, and plus 3.6 percentage points for graduate student loans. The interest rate would roughly work out to 3.86 percent this year for undergraduates and 5.42 percent for graduates. The Administration’s current FY 2014 proposed budget includes Income Based Repayment and Pay As You Earn (PAYE) plans for new, qualified borrowers who received disbursement after October 1, 2011.

As higher education has become a positive and important contributor to society, the government has an obligation to encourage participation by providing financial capital and assisting in the servicing of loans. The reduction of price and increase in availability for student loans conveys a subsidy to borrowers. Whether the subsidy is operating at a positive or negative level, is determined largely through accounting estimates. A recent Washington Post article noted, people disagree all the time about budget priorities. However, in budget debates, it also matters quite a lot how one adds up what people spend on different things, and student loans are a prime example.

Currently, the FCRA requires that student loans be calculated using the net-present value (NPV) method. Using this budget calculation method, the government is projected to make over $30 billion annually from the repayment of students debt. There remains debate as to the validity of these direct loan calculations and the FCRA procedures used to determine them. Of course, the dangers of using the net present value accounting method, lie in the uncertainty of future projections. There are a number of different variables including income based repayment plans, deferments, or forbearances, that will influence the amount and timing in which the government is actually paid back. A recent CBO report analyzed, that costs for all credit programs would be higher under the fair-value approach, because it accounts more fully than FCRA procedures do for the cost of the risk the government takes on when issuing loans or their guarantees. Opponents of the current budgetary policies argue, that using the treasury to discount expected cash flows results in a systematic understatement of the real costs associated with those loans. In particular, the fair-value approach accounts for the cost of market risk, and FCRA procedures do not.

When accounting for market risk, there is a certain amount of instability that may influence budgeting numbers. Fair-value accounting would have the propensity to become volatile due to fluctuations in market and interest rates. As the market has not fully recovered from the recession, there is still an immense value placed on risk premiums. The financial sector incorporates risk-adjusted discount rates and options-pricing methods in order to calculate loan returns. Diversified risk allows the government to bear minimal costs, but the market risk associated with these judgments makes for a budgetary challenge.

Considering that the default rate on student loans is a relatively large contributing factor to budget considerations, there should be a clearer, more accurate understanding of the default statistics. At the moment there is a lack of independent research regarding this issue. Budget authorities are forced to rely on Department of Education statistics and monetary projections. An independent review of student loan defaults and their effect on the budget forecasting should be commissioned. For instance, if a college’s former students turn out to default frequently, the college could be required to pay a substantial penalty.

Congress should pass a new budgetary form to address the ambiguity of direct loan subsidy rates. A new calculation method would have to take into account the government’s role for financing risky (students) investments, but also take into account market risks that will effect the principle and interest repayments of the loan.

Beyond budget accounting negotiations remains the reality that increased student loan participation, while providing increased opportunities in education, is burdening students and the overall economy by reducing consumer purchasing power. At the end of 2003, American students and graduates owed just $253 billion in aggregate debt; by the end of 2013, that same debt had ballooned to a total of $1.08 trillion, an increase of over 300 percent. It seems both counter-productive and unjustified to continue to charge heightened interest rates on these loans. Previous student loan holders should be allowed to refinance at current lower interest rates.

If the budget can sustain the decrease of interest repayment rates, the revenues could be used to generate greater student awareness and repayment assistance programs. This could be worked out to be nearly budget-neutral with increased revenues brought on by lower default rates, as well as allow for those members of society to fully contribute to the economy on their path to financial stability.

Opinion by Frederick Bates

Federal Credit Reform Act of 1990
The Washington Post
FFEL, Direct Loans, and Perkins Loans as well as some made under the Public Health Service Act

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