Why Lower Interest Rates Alone Won’t Fix the Student Loan Crisis

When Congress passed the Bipartisan Student Loan Certainty Act of 2013, interest rates were on the verge of doubling. Once the legislation was signed into law, however, rates fell, and the sponsoring politicians rushed to take credit for having solved a notorious problem for all time.

If only that were true.

Apart from the legislation’s absurdly contrived tiered-pricing methodology for loans to undergrads, grads and parents—which actually penalizes more creditworthy borrowers while contributing stunning levels of deficit-reducing profitability to the federal government (more on that in a moment)—there is the inconvenient issue of the accelerating rate of payment delinquencies and loan defaults that has taken place since.

I can think of four possible reasons for that: Demand for educated workers has significantly declined (it hasn’t), the troubled loans should not have been made in the first place (perhaps, but not to this degree), interest rates and fees are too high (yes, but not compared to other consumer-loan products), or the repayment term is too short (bingo!).

How the Government Profits From These Loans

Beginning with the matter of price, forget about how much money the government is raking in by funding high-rate, 10-year loans with low-rate, 3-month (or less) borrowings, because that scheme won’t continue too much longer. The Federal Reserve announced that it will begin tightening monetary policy very soon. Instead, consider how banks and other sophisticated lenders routinely finance fixed-rate loans with what is in effect “half-life” money.

For example, a 10-year loan would be funded with borrowing that is priced at the 5-year rate because—this gets a bit wonky—although the full principal balance is outstanding at the start of the loan, nothing will be due after the final payment is made. Therefore, it’s as if half of the loan’s value is outstanding at any given time during the term, hence the case for applying a 5-year funding rate.

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Mitchell D. Weiss

Mitchell D. Weiss is a financial services industry executive and entrepreneur. He is also an Executive-in-Residence at the University of Hartford, co-founder of the university’s Center for Personal Financial Responsibility and adjunct faculty at Rutgers University. His most recent text, Practical Finance - A Straightforward Guide to Personal and Entrepreneurial Finance, is the basis for the course he teaches at both institutions.

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