Stafford Loan Interest Rate Reduction: Background and Issues

Order Code RS22568 Updated July 20, 2007 Stafford Loan Interest Rate Reduction: Background and Issues David P. Smole Specialist in Social Legislation Domestic Social Policy Division Summary Subsidized and unsubsidized Stafford Loans are the primary sources of federal loan aid available to assist students finance the costs of a postsecondary education. These loans are made available under both the Federal Family Education Loan (FFEL) program and the William D. Ford Direct Loan (DL) program. Through these programs, students may borrow loans with terms and conditions that are generally more favorable than loans from private lenders. Effective July 1, 2006, the interest rate on new Stafford Loans is fixed at 6.8%. For loans made on or after October 1, 1992, and prior to July 1, 2006, interest rates are variable and adjust annually. Among other things, H.R. 2669, as passed by the House, would reduce interest rates on subsidized Stafford Loans that are disbursed to undergraduate students from July 1, 2008, to June 30, 2013. This report provides a brief overview of selected terms and conditions of Stafford Loans, characteristics of borrowers, and a description of how reduced rates proposed under H.R. 2669 would compare with terms and conditions under current law.1 Introduction The increasing return to obtaining a postsecondary education, rising college prices, and concerns about paying for college have increased the visibility of federal student aid programs. Of particular concern is the amount students borrow for college and their resulting debt burden. Also, recently implemented changes to the FFEL and DL programs have resulted in Stafford Loans disbursed on or after July 1, 2006, carrying a fixed interest rate of 6.8%; whereas in prior years, loans were disbursed with variable, annually adjusting, interest rates. In the early part of this decade, interest rates had dropped to historic lows, but recently have risen to levels more consistent with historic norms. The combination of recent interest rate changes, rising college prices, and concerns about student loan debt burden have put student loans on the agenda of the 110th Congress. 1 An earlier version of this report examined the interest rate reductions proposed in H.R. 5. This report has been updated to examine the interest rate reductions in H.R. 2669. CRS-2 In the 110th Congress, proposals are being considered to reduce interest rates on student loans to make them less costly to borrowers. On July 11, 2007, the House passed H.R. 2669, which would incrementally reduce interest rates on subsidized Stafford Loans for undergraduate students over a five-year period beginning with academic year (AY) 2008-2009. Under H.R. 2669, interest rates would be reduced from the current fixed rate of 6.8% to a fixed rate of 6.12% for loans disbursed in AY2008-2009; 5.44% for loans disbursed in AY2009-2010; 4.76% for loans disbursed in AY2010-2011; 4.08% for loans disbursed in AY2011-2012; and 3.4% for loans disbursed in AY2012-2013. Rates would then revert back to 6.8% for loans disbursed in subsequent years, unless the rate reduction was extended through other legislation. (Similar interest rate reductions were passed by the House as a stand-alone measure in H.R. 5.) H.R. 2669 would also make numerous other changes to the FFEL and DL program.2 FFEL and DL Stafford Loans Subsidized and unsubsidized Stafford Loans are made to undergraduate and graduate students under both the FFEL and DL programs.3 Under the FFEL program, loans are made by banks and other lenders to students in attendance at institutions of higher education (IHEs). Loan capital for FFEL program loans is provided by private lenders and the loans are guaranteed by the federal government against loss due to borrower default, death, permanent disability, or, in limited instances, bankruptcy. State and nonprofit guaranty agencies administer the federal loan guarantee. The federal government provides certain incentives to lenders, most notably the special allowance payment (SAP), which is a market-indexed loan subsidy payment designed to compensate lenders for the difference between the statutorily established borrower interest rate and a different statutorily established lender interest rate. Under the DL program, the federal government provides loans directly to students using federal capital (i.e., funds from the U.S. Treasury), and owns the loans. DL program loans are originated either by the institution a student attends or by a contractor of the U.S. Department of Education (ED). Loan servicing (i.e., billing borrowers, collecting payments, collecting on defaulted loans) is done by ED contractors. The DL program was initially intended to replace the FFEL program, but now both programs operate alongside one another. Each institution chooses whether to participate in the FFEL or DL program. Subsidized and Unsubsidized Stafford Loans. There are two types of Stafford Loans — subsidized and unsubsidized. Currently, the same interest rate applies to both types of loans — 6.8% for loans disbursed on or after July, 1, 2006. Subsidized Stafford Loans are available to undergraduate and graduate students to help them finance their postsecondary education expenses. The federal government “subsidizes” these loans 2 For additional information, see CRS Report RL34077, Student Loans, Student Aid, and FY2008 Budget Reconciliation, by Adam Stoll, David P. Smole, and Charmaine Mercer. 3 For additional information on the FFEL and DL programs, see CRS Report RL33673, Federal Family Education Loan Program and William D. Ford Direct Loan Program Student Loans: Terms and Conditions for Borrowers, by Adam Stoll (hereafter, CRS Report RL33673); and CRS Report RL33674, The Administration of the Federal Family Education Loan and William D. Ford Direct Loan Programs: Background and Provisions, by Adam Stoll. CRS-3 by paying the interest that accrues while the student is enrolled in school on at least a half-time basis, and during grace and deferment periods. Students must establish financial need to qualify for subsidized Stafford Loans. Unsubsidized Stafford Loans are also available to both undergraduate and graduate students. The major distinctions between the two types of loans are that for unsubsidized Stafford Loans, the federal government does not pay the interest that accrues while the borrower is in school or during deferment and grace periods; and students may qualify for unsubsidized Stafford Loans irrespective of their expected family contribution (EFC) (i.e., they are not need-based).4 Interest Rates. Both subsidized and unsubsidized Stafford Loans carry the same interest rate. For loans disbursed on or after July 1, 2006, the interest rate is fixed at 6.8%. For loans disbursed between October 1, 1992, and June 30, 2006, the interest rate is variable and adjusts annually. The formula used to calculate the variable interest rate for those loans is determined by statute and stays in effect from the time the loan is disbursed through the life of the loan, or until the loan is consolidated. The variable rate is calculated based upon the bond equivalent rate of the 91-day Treasury bill, plus a premium which differs depending on when the loan was disbursed; and whether the borrower is in school, a grace period, or deferment; or is in repayment. The interest rate on variable rate loans adjusts each year on July 1. Prior to October 1, 1992, Stafford Loans carried fixed interest rates. Table 1 presents a history of interest rates in effect during repayment on Stafford Loans disbursed on or after October 1, 1992.5 Table 1. Stafford Loan Interest Rates in Effect During Repayment: 1992-1993 through 2007-2008 Date 1992-1993 1993-1994 1994-1995 1995-1996 1996-1997 1997-1998 1998-1999 1999-2000 2000-2001 2001-2002 2002-2003 2003-2004 2004-2005 2005-2006 2006-2007 2007-2008 Disbursement Period Oct. 1, 1992 to July 1, 1994 to July 1, 1995 to July 1, 1998 to On or after June 30, 1994 June 30, 1995 June 30, 1998 June 30, 2006 July 1, 2006 6.94 6.22 7.43 8.92 8.26 8.26 8.26 7.72 8.99 6.79 4.86 4.22 4.17 6.10 7.94 8.02 7.43 8.25 8.25 8.25 8.25 7.72 8.25 6.79 4.86 4.22 4.17 6.10 7.94 8.02 8.25 8.25 8.25 8.25 7.72 8.25 6.79 4.86 4.22 4.17 6.10 7.94 8.02 7.46 6.92 8.19 5.99 4.06 3.42 3.37 5.30 7.14 7.22 6.80 6.80 Sources: U.S. Dept. of Education, Office of Federal Student Aid, FFEL Variable Interest Rates; and CRS Report RL32424, Consolidation Loans: Redesign Options and Considerations, by Adam Stoll. 4 5 See CRS Report RL33673 for more information on subsidized and unsubsidized Stafford Loans. Lower rates apply during in-school, grace, and deferment periods; however, since for subsidized Stafford Loans, interest is paid by the federal government during these periods, these rates are not shown. (Lenders may make loans at lower interest rates or reduce rates for timely repayment.) CRS-4 H.R. 2669 would reduce interest rates only for undergraduate borrowers of subsidized Stafford Loans. The interest rate on subsidized Stafford Loans borrowed by graduate and professional students and on all unsubsidized Stafford Loans would remain at 6.8%. As shown in Table 1, for loans disbursed on or after October 1, 1992, interest rates during repayment on Stafford Loans have been at or lower than 3.4% only during the period from July 1, 2004, to June 30, 2005, and only for loans disbursed on or after July 1, 1998. For most of the history of the Stafford Loan program, interest rates on variable rate loans have been at or above 6.79% during repayment.6 (For purposes of comparison, under the Federal Perkins Loan program — the other major subsidized student loan program — all loans disbursed on or after October 1, 1981, carry a fixed interest rate of 5.0%.) The proposed interest rate reduction would result in increased costs to the government under the FFEL program due to larger SAP payments to lenders; and under the DL program due to receipt of reduced revenue from interest payments.7 Loan Volume and Characteristics of Borrowers Loan Volume. Borrowing under the subsidized and unsubsidized Stafford Loan programs constitutes the largest single source of direct federal student aid to help students finance their postsecondary education expenses. In academic year FY2006, more than $36 billion in subsidized and unsubsidized Stafford Loan aid was made available to undergraduate students under the FFEL and DL loan programs. The number of undergraduate borrowers and committed loan volume for FY2006 is presented in Table 2 for both programs. Table 2. FFEL and DL Undergraduate Borrowers and Committed Loan Volume: FY2006 FFEL FFEL Loan DL DL Loan Total Loan Borrowers Volume Borrowers Volume Volume Subsidized 4,394,000 $15,537,000,000 1,148,000 $4,113,000,000 $19,650,000,000 Unsubsidized 3,345,000 $13,505,000,000 778,000 $2,949,000,000 $16,454,000,000 Loan Type Source: U.S. Dept. of Education, Office of Postsecondary Education, National Student Loan Data System. Income Distribution of Borrowers. Data on the distribution of undergraduate Stafford Loan borrowers in AY2003-2004, by 2002 income percentiles are presented in Table 3. The table shows total 2002 income for the parents of dependent students and for independent students and their spouses at selected percentile point breaks. For instance, column B shows incomes for various categories of students at the 25th percentile (i.e., 25% of students have lower incomes); and column C shows median incomes. 6 However, interest rates have also been lower on federal student loans. For example, Guaranteed Student Loans (GSLs) were originally made at a fixed interest rate of 6%; and borrowers whose income was below a certain threshold at the time of disbursement were eligible to have 3 percentage points of their interest paid by the federal government (P.L. 89-329, § 428(a)(2)). 7 An examination of the cost to the government of this proposal, and issues such as its effect on student access to and persistence in postsecondary education are beyond the scope of this report. CRS-5 Table 3. Income Percentile Distribution of Undergraduate Stafford Loan Borrowers: AY2003-2004 10th Percentile (A) Dependent All students Stafford borrowers total Subsidized Stafford Unsubsidized Stafford Independent All students Stafford borrowers total Subsidized Stafford Unsubsidized Stafford 25th Percentile (B) 50th Percentile (C) 75th 90th Percentile Percentile (D) (E) $16,305 $17,519 $14,553 $24,862 $32,370 $31,842 $26,353 $45,885 $59,443 $55,827 $44,681 $75,837 $91,754 $85,540 $67,373 $104,201 $130,485 $117,266 $91,468 $141,376 $3,500 $3,519 $3,335 $4,000 $11,214 $9,355 $8,924 $10,272 $25,415 $20,052 $19,034 $21,483 $49,415 $35,394 $32,272 $37,855 $77,031 $57,533 $51,228 $61,020 Source: U.S. Dept. of Education, National Postsecondary Student Aid Study, 2004 (NPSAS:2004); CRS calculations. Notes: Income data are 2002 total income. Data on borrowers of subsidized Stafford Loans and unsubsidized Stafford Loans are not mutually exclusive. Since students qualify for subsidized Stafford Loans on the basis of need, it is not uncommon for students whose subsidized Stafford Loan amounts are less than the statutory maximum to borrow the difference between their subsidized Stafford Loan eligibility amount and the statutory maximum through unsubsidized Stafford Loans. Thus, many students borrow both types of loans. Both dependent and independent Stafford Loan borrowers are distributed across a slightly lower income range than undergraduate students overall. However, for dependent students, there is considerable variation between the income distribution of borrowers of subsidized Stafford Loans and borrowers of unsubsidized Stafford Loans. Dependent student borrowers of subsidized Stafford Loans had a median 2002 income of $44,681, compared with a median income of $75,837 for borrowers of unsubsidized Stafford Loans. There was less variation among undergraduate independent borrowers, with the median income of borrowers of subsidized Stafford Loans being $19,034, compared with $21,483 for borrowers of unsubsidized Stafford Loans. Subsidized Stafford Loan Borrowing. During AY2003-2004, 27.7% of undergraduate students borrowed subsidized Stafford Loans, and these students borrowed an average amount of $3,232.8 Borrowers who graduated that year, had borrowed an average cumulative amount of $10,842 in subsidized Stafford Loans.9 Loan limits on Stafford Loans vary by class level, with annual loan limits rising as students progress through college. The amount students actually borrow also tends to increase as they become eligible for larger loan amounts. Table 4 presents information on average amounts borrowed by undergraduate students during AY2003-2004 and current loan limits for subsidized Stafford Loans for undergraduate students. (Effective July 1, 2007, loan limits increased to $3,500 for first year undergraduates; and to $4,500 for second year undergraduates.) 8 U.S. Dept. of Education, NPSAS:2004; CRS calculations. 9 Ibid. CRS-6 Table 4. Subsidized Stafford Loans for Undergraduate Students: Average Borrowing in AY2003-2004 and Current Loan Limits Borrowing by Class Level: AY2003-2004 Percent Who Average Amount Class Level Borrowed Borrowed 1st year 27.4 $2,190 nd 24.4 $2,932 2 year 37.8 $4,360 3rd year 35.8 $4,288 4th year 32.3 $4,138 5th year Statutory Loan Limits Loan Limita Class Level 1st year 2nd year 3rd year and beyond $3,500 $4,500 $5,500 Sources: U.S. Dept. of Education, NPSAS:2004; CRS calculations; and HEA, § 428(b)(1)(A). Note: a. Prior to July 1, 2007, loan limits were $2,625 for 1st year students, and $3,500 for 2nd year students. Interest Amortization. The amount of interest a borrower pays over the life of a subsidized Stafford Loan is a function of the amount borrowed, the interest rate, and the duration of the repayment period. Reduced interest rates on subsidized Stafford Loans could substantially affect the amount of interest borrowers pay over the life of their loans. Table 5 presents case simulations of two types of borrowers at current interest rates and at the rates proposed under H.R. 2669. Case A is a borrower who first enrolls in AY2008-2009 and over five years borrows $2,250 in year 1; $3,000 in year 2; and $4,250 in each of years 3 through 5. Case B is a borrower who begins enrollment in AY20082009 and over five years borrows $2,500 each year. Each case shows repayment under a standard 10-year repayment plan. Table 5. Case Simulations of Monthly and Total Payments on Subsidized Stafford Loans: Current Interest Rates and H.R. 2669 Case Borrower A Current rates H.R. 2669 Savings Borrower B Current rates H.R. 2669 Savings Aggregate Borrowed Blended Interest Ratea Monthly Payment Total Interest Total Repayment $18,000 $18,000 6.80% 4.56% $207.14 $187.18 $19.96 $6,857 $4,462 $2,395 $24,857 $22,462 $2,395 $12,500 $12,500 6.80% 4.76% $143.85 $131.20 $12.96 $4,762 $3,244 $1,518 $17,262 $15,744 $1,518 Source: CRS calculations using CRS Interest Amortization Tool. Note: a. The blended interest rate is the weighted average of the interest rates on each loan borrowed. Table 5 shows that compared with borrowing at current interest rates, under H.R. 2669, Borrower A would save $2,395 in total interest over a 10-year repayment period, while Borrower B would save $1,518. Borrower A, would pay 34.9% less in interest over the duration of the loan, and would pay 9.6% less per month and in total payments of principal and interest. Borrower B would pay 31.9% less in interest, and 8.8% less overall. However, each borrower’s monthly payment would be reduced by less than $20.