Rising Student Loan Interest Rates Will Hurt Taxpayers

Interest rates on federal student loans will rise slightly next year. Loans to undergraduates issued in the 2017-18 academic year will be 4.45%, up from 3.76% currently. Rates on standard loans to graduate students will rise to 6%, while rates on PLUS loans to graduate students and parents will reach 7%. While all of these rates represent an increase from the current year, all are still lower than they have been for the better part of a decade.

One would think that rising student loan interest rates would benefit taxpayers at the expense of student borrowers. But in reality, the exact opposite is true.

Since 2013, interest rates on federal student loans have moved directly with the yield on a 10-year U.S. Treasury bond, instead of being set by Congress at a fixed level. Theoretically, this ensures that the taxpayer cost of the student loan program remains roughly constant. Since the federal government runs a deficit, it must issue Treasury bonds to raise any marginal funds it requires to finance the upfront costs of student loans. When the government’s borrowing costs rise, student loan interest rates rise as well, and with them future revenues from the loan program.

So even if student loan interest rates rise, net revenue for taxpayers may not rise because the government’s borrowing costs have also gone up. But there’s another wrinkle.

Under a traditional repayment plan, a borrower’s monthly payments rise and fall with his balance and interest rate. For instance, a borrower with an undergraduate loan balance of $25,000 makes annual payments of $2,503 under current interest rates and $2,585 under next year’s rates. But a new sort of financial invention-the income-based repayment (IBR) plan-decouples monthly payments from interest entirely.

Under IBR, all eligible borrowers, regardless of balance or interest rate, make annual payments equal to 10 percent of their discretionary income. After making 20 years of payments, any remaining balances on their loans are forgiven.

For borrowers with small balances, IBR sometimes doesn’t provide much value, since it involves a longer repayment periods-20 years versus 10 years under the standard plan. But for borrowers with large balances, it’s a windfall. Not only are monthly payments reduced, but many borrowers are eligible to have their balances wiped out after 20 years.

That benefit is obvious. But many observers have failed to appreciate another benefit of IBR: it insulates participating borrowers from rising interest rates. Since payments are tied to income, not balances or rates, a higher interest rate has no effect on monthly payments, all else being equal. But a higher interest rate does mean that more of your monthly payment applies toward interest rather than principal on the loan. At high interest rates, IBR payments may not even be enough to cover interest, meaning principal balances continue to grow and grow-until Uncle Sam forgives them.