Guest Post: Should We Give Up the In-School Subsidy on Student Loans?

[Editor's Note: Last month, George Miller, the Democratic chairman of the House of Representatives Committee on Education and Labor, created a furor when he included a provision in a student loan reform bill that would have eliminated the in-school interest subsidy on federal Stafford loans for graduate and professional students. Warning that the provision was a "deal breaker," lobbyists for colleges and advocates for graduate students forced Miller to reverse course and remove the offending provision from the bill. In this guest post, student-aid expert Sandy Baum explains why eliminating the in-school interest subsidy for both undergraduate and graduate students -- and redirecting the savings to help financially distressed borrowers repay their debt -- is a worthwhile public policy endeavor.]

By Sandy Baum

In these difficult economic times, the struggles of many students both to pay for college and to repay their student loans are all too visible. It is no surprise that suggestions to eliminate the in-school subsidy on Stafford Loans elicit strong objections from many people concerned with these struggles. But particularly in these difficult economic times it is vital that we find the best ways to help students -- ways that are equitable and that use limited funds as efficiently as we can to make college affordable for as many students as possible.

Students with documented financial need are eligible for subsidized Stafford Loans, for which the government pays the interest while the student is in school, for six months after the student leaves school, and during qualifying periods of deferment. Students without documented financial need and those who have borrowed the maximum amount of subsidized loans for which they are eligible can borrow unsubsidized Stafford Loans, on which the interest accrues while they are in school and during other periods of non-payment. The interest rate on subsidized loans is now lower for the life of the loan than the interest rate on unsubsidized loans.

Not Well Targeted

This policy might be a good one if subsidized loans consistently went to financially distressed students who will have the most difficulty repaying their student loans, and if this group of students could count on getting all the subsidized loans they need so interest would not accrue on any of their federal loans while they are in school. However, neither of these conditions holds. The almost $8 billion per year spent on the in-school subsidy could do much more to help make education affordable if the loan programs were re-designed to focus on diminishing the repayment burdens of those who are struggling the most to pay back their loans.

In 2007-08, 25% of dependent students from families with incomes below $30,000 took only subsidized Stafford loans, but 13% (over 800,000) relied on unsubsidized Stafford Loans as well, according to the most recent student aid data from the Department of Education. At the same time, 39% of the subsidized Stafford Loans going to dependent students went to those from families with incomes above $60,000. In other words, even if pre-college circumstances were the only relevant measure, the Stafford Loan system would not be doing a good job of targeting its subsidies.

The lack of targeting results partly from allowing cost of attendance to enter into the eligibility criteria, so that students who qualify for the subsidy at high-priced institutions may have significantly higher incomes than many who do not qualify because they attend lower-priced colleges. Also, students who are in school for the longest time -- those who go to graduate school -- benefit most and they rarely either come from the lowest-income families or end up with low earnings. In addition, under the current system, with all students allowed to borrow more Stafford Loans than the amount of subsidized loans to which they have access, the proportion relying on both types will increase, contributing to complexity and confusion.

But most important, financial circumstances before college are not the primary determinant of borrowers' ability to repay their loans. It is certainly true that borrowers from low-income families are most likely to struggle with their loans because their parents are unlikely to be able to help them either with their payments or with other expenses. But this reality does not mean that borrowers from middle- and upper-income families are protected from repayment difficulties. In the current economy, examples of students from relatively affluent backgrounds with strong academic credentials who find themselves unemployed or employed in low-wage jobs are easy to find. And many of those students will find that their parents are now in no position to help.

A Better Solution for Borrowers

The new Income-Based Repayment Plan is a great step in the right direction, protecting students whose incomes do not support their federal loan payments. But it is not a complete solution to the problem. Those with unsubsidized loans -- and those with subsidized loans whose incomes are low for long periods of time -- will see interest accruing on their debt. Even if they are protected from default, they will face growing balances that could negatively affect their financial futures. As a result, it will take significantly more funding for the IBR program to provide the necessary safety net for student borrowers. The almost $8 billion dollars a year that could be saved by abandoning the in-school subsidies could, in addition to providing more funds for Pell Grants and other student aid programs, make a big difference in our ability to protect student borrowers from financial distress during repayment.

If we shifted these subsidies to the repayment period, we would be able to make a meaningful promise to students and potential students that they could borrow the funds they need to make college accessible without being worried about overly burdensome debt payments in the future. Needed improvements include having the government cover the interest payments for all borrowers whose IBR payments are lower than interest due for some period of time -- say one year -- and then capping the total amount of debt that can accrue at, for example, 150% of the amount borrowed. In addition, remaining debt should be forgiven after 20 years instead of 25 years and when this occurs, it should not be a taxable event, as it is under the program's current design.

Necessary Trade-Offs

The purpose of the in-school subsidy is to reduce the payments borrowers will have to make after they graduate, but the current system does not provide the safety-net its supporters claim. Students have little understanding of the difference between subsidized and unsubsidized loans (or unfortunately, of the difference between federal and private loans). What they do understand is their payments once they leave school. A student who borrows $5,000 a year for four years at 3.4% interest would owe $20,000 with in-school subsidies and face monthly payments of about $197. The same borrowing without the in-school subsidy would lead to a debt of about $21,800 and monthly payments of about $214. At a 6.8% interest rate, the debt would be about $23,600 unsubsidized and the monthly payments would be about $272. But the real issue, whether the debt results directly from borrowing or from accrued interest, is whether the borrower can afford the monthly payments. And only a better-subsidized IBR repayment program can address this issue.

The subsidized Stafford Loan program also introduces unneeded complexity into the student aid system. Students cannot predict their eligibility for subsidized loans, which depends on a combination of the complex federal need analysis formula and the cost of attendance at the institution at which they are enrolled. Steps to simplify the aid application process and the need analysis formula are currently being implemented by the Department of Education and considered by Congress. But because of their more complex financial situations, a simple methodology that would be effective for allocating Pell Grants would not be appropriate for the more affluent families with children eligible for subsidized loans at expensive institutions. Removing the in-school subsidy and moving the subsidies to the repayment period would eliminate the need to evaluate family financial circumstances in allocating Stafford loans and would allow students to know their loan eligibility in advance.

We need to simplify and strengthen the student aid system and make it more generous. But it will work best for students if we are flexible enough in our use of federal resources to trade some of the existing subsidies for funding that will be better targeted, easier to understand, and more effective in solving student financing problems. Students need the money that is now going to in-school subsidies -- but they need it in better designed, more effective programs.

Sandy Baum is a senior policy analyst at the College Board and an independent consultant. She has written extensively on issues relating to college access, college pricing, student aid policy, student debt, affordability and other aspects of higher education finance. She was also one of the founders of the College Board's Rethinking Student Aid Study Group, which released in 2008 an ambitious plan for overhauling the federal financial aid programs. Her views are her own and do not necessarily reflect those of the New America Foundation.