Private Loans

In his State of the Union address, President Obama called on Congress to prevent federal student loan interest rates from doubling later this year. This is the culmination of decades of legislative changes to the federal student loan program. Few people are aware of the policies that led to the pending student loan interest rate increase and many question whether the 6.8 percent fixed interest rate charged on the most widely-available loans provides a real benefit to students.

The Federal Education Budget Project today released an issue brief regarding federal student loan interest rates. This issue brief details the history of interest rates on federal loans, including the decisions that led to today’s fixed rates and the pending rate increase. It also examines the popular argument that current rates are unfavorable for borrowers and disputes the claim that student loans earn revenue for the government. 

The timeline below shows the interest rates on federal student loans taken out in each year, as well as the Congressional action that led to these interest rates. Roll over the points in the graph for more information.

Segment Transcript:

Kai Ryssdal: We're probably still a couple of lawsuits away from figuring out exactly how much power the Consumer Financial Protection Bureau's eventually going to have. Senate Republicans say they're going to challenge President Obama's recess appointment of Richard Cordray to run the agency. The president says he did it because without a permanent director, the bureau couldn't do key parts of its job. One big part of which is regulating what're called non-bank activities -- check cashing, debt collection, payday lending.

This week everyone has been talking about student loans. The Obama administration announced some minor changes to the Direct Loan program. Separately, the House Education and Workforce Committee held a hearing to examine the program’s performance since Congress ended the bank-based guaranteed loan program last year. At the same time, some “Occupy Wall Street” protestors have been demanding relief from student loans. With all this attention on federal student loans, the direct-loans-are-profitable-for-the-government argument has been out in full force.

For example, at the House hearing Rep. John Kline (R-MN) said an interest rate of “6.8 percent when the federal government is borrowing at less than 1 percent can create a pretty big slush fund.” Democrats on the committee agreed with Kline that the government is earning money off of the program but argued lawmakers should consider lowering the interest rate that students pay to no more than what it cost the government to borrow and pay for loan defaults.

Generally, liberals, student advocates, and lobbyists for colleges say that Direct Loan profits suggest that the government is “overcharging students.” To conservatives and student loan companies, Direct Loan profits mean the government is competing with private businesses in providing a for-profit service.

Those would all be valid arguments except for the fact that the Direct Loan program doesn’t make money and it isn’t profitable.

The Direct Loan program issues about $100 billion in new student loans each year with over $500 billion in loans currently outstanding. The program charges undergraduates fixed interest rates between 3.4 percent and 6.8 percent. Graduate students get the same rates, but can borrow additional amounts at 7.9 percent interest rates under the Grad PLUS program. All students qualify for at least some type of loan regardless of their financial need. Repayment plans can be as long as 30 years and borrowers experiencing “economic hardship” can postpone payments for up to three years under deferment and forbearance policies, or can repay under income-based repayment plans. The government also forgives loans under a number of circumstances.

It’s common knowledge that banks make money by borrowing at low interest rates and making loans at higher rates. In the most basic sense that is a fair characterization. Many people therefore assume that Direct Loans are profitable for the government because the fixed interest rates borrowers pay are twice as high (or more) as what it costs the government to borrow.

But if the profitability of the loans is simply equal to the difference between these two interest rates, why don’t private banks make student loans at the same terms as the government? They can borrow at low rates too.

Take a look at the interest rate banks pay on savings accounts. It’s less than a third of a percent. A ten-year certificate of deposit pays 2.5 percent interest. Those rates are pretty close to U.S. Treasury rates, and they should be – bank deposits are insured by the federal government. They are certainly lower than the interest rate the government charges on student loans. But you won’t see your local non-profit credit union offering terms as good as a federal Direct Loan. That is because banks believe making loans at those interest rates and with those types of repayment plans is too risky relative to what the bank can expect to get in return. In other words, private banks are not willing to take on the risk associated with these loans at such low interest rates.

Of course, there are far more technical and complicated ways to explain why Direct Loans don’t make money, but we will leave those for another time. For now, take it as proof that not even the most efficient, most profitable banks in the country make loans as generous as those in the Direct Loan program because it is a money-losing endeavor.

It’s not bad, however, that the loans don’t make money. They aren’t supposed to. In fact, the government’s loss on the loans serves as a subsidy for the student who borrows to pay for school. According to a 2010 Congressional Budget Office study(page 10), the typical student gets a 12 percent subsidy on his federal Direct Loan. Put another way, the borrower receives a government benefit worth 12 percent of the amount he borrows. A $5,000 loan, therefore, provides a $600 government benefit to the student.

Regardless of these facts, any debate about federal student loans will inevitably be based on the false premise that the loans are profitable for the government. When the interest rate on subsidized Stafford loans jumps from 3.4 percent to 6.8 percent next school year, you can be sure there will be cries of usury. And as the Obama administration makes the case that the incentives it offers students to switch their loans over to the Direct Loan program save money overall, you can be sure some lawmakers will claim all of those savings come from profits earned off of students. Neither argument is true.

The investment banking industry – and its friends in Congress – have cooked up a scheme they are pitching to the “supercommittee” that they say would reduce the federal debt and cut federal spending. Supposedly, the plan would take the government’s $555 billion direct student loan holdings off of its books. In reality, the plan, which would allow the bankers to earn fees on a $555 billion deal, plus $100 billion more every year, would not reduce the debt or cut spending. But that hasn’t stopped Wall Street from trying.

A proposal that could only have been be cooked up by investment bankers is circulating on Capitol Hill. It would refinance the $555 billion direct student loan portfolio with new debt backed 100 percent by the federal government. But this new debt would not be called U.S. Treasury debt, despite the 100 percent guarantee, and therefore not counted as part of the national debt. In other words, the new debt would be used to pay off the old debt (Treasury bonds) that the government issues to finance direct student loans. To be sure, the mechanics of the proposal are more complicated than that, but the effect of the proposal would be to move all outstanding and future student loans from bonds backed 100 percent by taxpayers to another set of bonds backed 100 percent by taxpayers but not counted as part of the national debt.

That wouldn’t be quite so ridiculous of a proposal if it didn’t also increase spending and increase the annual budget deficit. In other words, the phony debt reduction that the proposal is based on would come at a significant cost to taxpayers compared to the status quo.

In August, the U.S. Department of Justice (DOJ) joined a federal False Claims lawsuit against Education Management Corporation (EDMC), charging that the for-profit college company defrauded the government by defying a federal law prohibiting colleges from compensating recruiters based on their success in enrolling students. If the case is allowed to proceed, it could lead to embarrassing revelations not just about EDMC, but about the for-profit higher education industry writ large.

So it shouldn’t come as a surprise that career college leaders and lobbyists have mounted what appears to be a public relations campaign aimed at pressuring the Justice Department to either back down or enter into settlement talks with EDMC before any more of the industry’s dirty laundry is exposed.

Now that the new Consumer Financial Protection Bureau (CFPB) has opened its doors, what can it do to make private student loans safer for students?

In recent days, both our colleagues at the Project on Student Debt and student aid expert Mark Kantrowitz have recommended steps the CFPB can take to achieve this goal. At Higher Ed Watch, we have sifted through these proposals and chosen five that we think will do the most to help students avoid taking on unnecessary debt and keep private student loan providers honest. [Editor’s Note: Higher Ed Watch is supported in part by a grant from the Institute for College Access and Success, which runs the Project on Student Debt.]

In our opinion, the bureau should:

• Require lenders to get colleges’ permission before providing private loans to their students

The single most important step that the CFPB can take to stop students from borrowing private loan debt unnecessarily is to require colleges to certify a student’s need for these loans before that individual can receive them. By instituting such a requirement, the bureau would give college financial aid administrators the opportunity to counsel students to ensure that they have exhausted their federal loan options before taking out higher cost and riskier private loans. The Project on Student Debt’s new report, “Critical Choices: How Colleges Can Help Students and Families Make Better Decisions about Private Loans," shows how crucial this counseling can be in helping students make better borrowing choices.

When the new Consumer Financial Protection Bureau starts its work on private student loans in earnest, it will have to confront a question that has vexed policymakers and student aid experts in recent years: Why do so many students take on this debt without exhausting their eligibility for federal loans first?

According to the most recent data available from the Department of Education, the majority of undergraduates who borrowed private loans in the academic year 2007-08 did so even though they hadn’t taken out all of the federal loan debt for which they were qualified. Nearly one quarter of these private loan borrowers did not take out any federal loans at all.

This is a major public policy problem because private loans are far more risky than federal loans and almost always much more expensive. Unlike federal loans, which carry a fixed rate, private loans generally have uncapped interest rates that vary month to month based on market conditions. While federal loans offer the same terms to all borrowers, private loan providers tend to charge higher rates to those with the greatest need.

Federal loans also offer much greater consumer protections than private loans. Borrowers in the federal programs who become unemployed or suffer economic hardship, for instance, have a legal right to have their loans deferred for several years. Private loan borrowers who run into trouble don't have that option. And unlike federal loans, private loans are not automatically discharged if a borrower dies, is permanently disabled, or attends a school that unexpectedly shuts down before that student completes his or her studies.

Starting Thursday, there will be, for the first time, a single federal agency in charge of regulating private student loans. The new Consumer Financial Protection Bureau (CFPB) replaces a patchwork of government agencies that for years turned a blind eye to the predatory private loan practices that we at Higher Ed Watch have helped expose since the blog’s start in 2006.

The Dodd-Frank financial overhaul bill that Congress approved last year put the new bureau in charge of writing rules that apply to all private student loans, including those offered by non-banks, such as Sallie Mae and for-profit colleges. It also gave the CFPB full oversight and enforcement authority over non-banks and banks with more than $10 billion in deposits. In addition, the legislation established a new Private Student Loan Ombudsman within the CFPB who will not only assist borrowers but will also analyze complaints that are filed with the bureau against lenders to determine whether there are any clear patterns of abuse -- and make policy recommendations to Congress and the administration to address them.

The bureau, however, will not be at full strength at the start. That’s because the law requires the CFPB to have a permanent director in place before it can carry out many of the consumer protection responsibilities that Congress assigned it. While President Obama on Monday nominated former Ohio Attorney General Richard Cordray to lead the CFPB, Senate Republicans have vowed to block his confirmation until major changes are made to the bureau’s structure that would significantly weaken it.

Nevertheless, the increased oversight that the new entity promises to bring to non-federal student loans is extremely welcome, particularly at a time when the private student loan marketplace appears to be on the rebound.

[Editor’s Note: In this guest post, student aid expert Sandy Baum explains why greater regulation of the for-profit college sector is warranted. The post is mostly adapted from a piece she wrote for The Chronicle of Higher Education's Innovations blog, with other parts coming from testimony she delivered earlier this month at a Senate Health, Education, Labor and Pensions Committee hearing on student indebtedness at for-profit colleges.]

By Sandy Baum

The debate about for-profit institutions and student debt is too often framed in ideological terms. Free-market conservatives tend to be on the side of the for-profits. They complain that critics are trying to prevent market forces from working and are apologists for the inefficient nonprofit sector of higher education. Politically liberal voices tend to weigh in on the other side, sometimes arguing that the intrusion of the profit motive into the education arena is incompatible with the interests of students.

The problem of student debt among students at for-profit postsecondary institutions is not a matter of free markets versus government intervention. The market for higher education does and should rely heavily on market forces. However, it is not and never will be a textbook example of competitive markets. The for-profit sector, which has the potential to make important contributions to educational opportunity in the United States, relies on the federal government for most of its revenues. In fact, very few students are actually paying with their own money to enroll in these institutions.

[Editor's Note: This post has been updated to provide more clarity on the terms of Corinthian's institutional loan program, and on its cohort default rates over the past five years.]

At nearly one-third of Corinthian College campuses, more than half of all first-year students took out high-cost private student loans in 2009, according to an analysis of Department of Education data. Given this data and Corinthian’s dismal record on student loan repayments and defaults, we at Higher Ed Watch believe that it is entirely appropriate for federal officials to ask whether this giant for-profit college company is doing more harm than good.

We used the U.S. Department of Education IPEDS database to examine the top 100 colleges in terms of non-federal loan borrowing in 2009. At each of these schools, at least 52 percent of first-year students borrowed private loans. We found that 82 of the institutions were in the for-profit college sector. The remaining schools included 17 private colleges and one historically black public university.

Of the for-profit schools, 30, or close to 40 percent, belonged to Corinthian Colleges. These included 27 of the company’s Everest schools and three of the six Wyotech campuses. At five of the Everest schools, more than three-quarters of first-time students had private loans. The largest share of private loan borrowing occurred at the Everest College branch in Chesapeake, VA, where nine out of 10 of these first-year students took on these risky loans. Overall, the median rate for these institutions was 66 percent.