I started law school in 2005 and graduated in 2008. I was admitted to the California Bar later that year, and have been practicing law ever since. My law school education was financed entirely through government backed loans. As most of you know, law school is not cheap. After tuition and living expenses, many law students borrow in excess of $50,000 per year for three years. Even worse, the interest rates on federal student loans are inexplicably high. For instance, my largest loan (a Grad PLUS loan) carries a fixed 8.5% interest rate.
I've been fortunate enough to have a job since graduation. As a result, I've been able to make my monthly loan payments. Every year around tax time, I see how much interest I pay on my student loans. I am shocked every time. After paying so much interest year after year, I started to wonder...does the government actually make money on student loans? After a little research, I discovered the answer. Yes. A LOT OF MONEY. I will tell you how much (per the CBO), and how that happened, below the fold.
The history of federal student loans. In 1965, Congress enacted the Higher Education Act (“HEA”). The HEA permitted the federal government to create two programs to help students finance higher education: the Federal Family Education Loan (“FFEL”) program, which dates back to the mid-60s, and the William D. Ford Federal Direct Loan Program (“FDLP”), which began in 1994. The primary difference between the FFEL and the FDLP is that the FFEL guaranteed loans made by private lenders, while the FLDP authorized the federal government to loan money directly to borrowers. A more detailed history of the federal student loan program can be found here.
FFEL loans carried a variable interest rate. The program also allowed students to consolidate their loans into one loan with a fixed interest rate. On the other hand, FDLP loans carry a fixed interest rate. A fixed rate provides the government with more certainty for future budget calculations. In addition, fixed rates can lead to additional revenue for the government in times (such as now) when interest rates are low. For example, the interest rate on a 90-day T-Bill in 2009 was 0.21%, while the interest rate on Stafford loans for the same period was 5.6%.
In 2010, Congress passed the Health Care and Education Reconciliation Act ("HCERA"). The HCERA eliminated the FFEL program altogether. By eliminating the middleman on FFEL loans (i.e., private lenders) the government projected a savings of $68.7 billion over 10 years. These savings were used to increase funding to the Pell Grant Program.
Why student loans are important. Over the last twenty years, the cost of education has risen dramatically. With it, the student loans issued or guaranteed by the federal government have increased in kind. In a recent article, the Consumer Financial Protection Bureau stated that outstanding student loan debt has topped $1 trillion. According to the same article, students took out $117 billion in federal loans in the last year alone.
Despite the shocking sticker price, it makes fiscal sense to get a degree. Indeed, empirical evidence shows that higher education leads to higher pay. A 2002 report by the US Census called The Big Payoff tells us that workers with a high school diploma can expect to earn an average of $25,900 per year. College graduates can expect to earn an average of $45,400 per year. Workers with professional degrees (e.g., doctors, lawyers, and engineers) earn an average of $99,300 per year.
The government also benefits from educated citizens. Higher earners pay more taxes. More tax revenue means more money for federal and state budgets. Logically, Congress should use its legislative powers to encourage higher education through low cost student loans. Unfortunately, the opposite is true. Over the years, Congress’s student loan legislation has been consistently unfavorable to student borrowers, including the drastic step of making student loans non-dischargeable in bankruptcy. (11 USC 523(a)(8).)
Surprise! Student loans are not a risky bet for the government. A student loan is an unsecured debt, and most students have little or no assets when the money is borrowed. To combat the risk of default, the government uses prophylactic measures including loan forbearances and deferments. These tools allow borrowers to stop making payments during periods of financial hardship without defaulting on their loans. Borrowers, however, should only use this relief as a last resort, since interest continues to accrue and compound while the loans are not being repaid. This will result in a substantially higher principal balance that will ultimately have to be repaid by the borrower.
The government also uses punitive measures to combat default. These include: (1) making student loans non-dischargeable (with rare exceptions); and (2) garnishing Social Security payments. Under current law, Social Security payments can be garnished up to 15% until the federal student loan has been repaid with interest and penalties. (31 USC 3716(c)(1)(c).) Unlike private debts, the Federal government can garnish Social Security payments regardless of when the default occurred. Stated differently, there is no statute of limitations on student loans owed to the government. (20 USC 1091(a).)
Borrowers know (or should know) that they cannot escape their student loans through bankruptcy. Indeed, federal loans can and will follow defaulting borrowers into their retirement years and probably until death. As a result of the foregoing, collection rates on student loans have increased dramatically. The government can keep lending because it knows, sooner or later, it will collect.
All this means big revenue for the government. The increased cost of education, the poor economy (less jobs = more students) and elimination of the FFEL program in 2010 created a perfect storm of student lending which has become immensely profitable for the government. According to the Congressional Budget Office, the subsidy rate for student loans disbursed this year is negative $37 billion. (Table 1.) In other words, the federal government will receive a positive cash flow of $37 billion on loans disbursed in 2012 alone. Administrative costs over the same period (including defaults) are less than $1 billion. (Table 4.)
The large negative subsidy is caused, in part, by the federal government charging borrowers high interest rates while market rates are low. The most glaring example is the PLUS Loan (Grad PLUS and Parent PLUS loans). PLUS Loans are for graduate and professional degree students, and become available once Stafford lending limits are reached. PLUS Loans currently carry a 7.9% interest rate, in addition to a 4% surcharge of the total amount disbursed each time a PLUS Loan is made. The result of these unfavorable borrowing terms is a whopping subsidy rate of approximately -60% on Grad PLUS loans and -51% on Parent PLUS Loans. Stafford loans are not much lower; the subsidy rate for Unsubsidized Stafford Loans is approximately -35%. The total subsidy rate for all new loans disbursed in 2012 is -30.5%. (Table 2.)
The government must treat students better. Under the current system, students who borrow money from the government to finance their education should expect above-market interest rates, no possibility of bankrupting out of the debt, and debt collectors following them until death if they ever default. In sum, students who take out student loans face a Hobson’s Choice: either accept the government’s awful borrowing terms, or go into the workforce without an education.
Why are students, who can least afford to pay, quietly treated as a profit center by the government? Why do our elected officials continue to pretend like the government doesn't make money on student loans? It's hard to say. It may be due to the lack of a strong student lobby in Washington D.C.
The government must treat student borrowers better. At a minimum, students who dutifully pay their loans every month should be given some form of relief, in the form of reduced interest rates or tax write-offs. In my next diary, I will discuss some ideas to start reforming the federal student loan program. Thanks for reading.