The Detriment of Keeping Interest Rates Artificially Low on Federal Student Loans

Yesterday, the House of Representatives passed the Bipartisan Student Loan Certainty Act of 2013 (H.R. 1911), which is supposed to keep interest rates for federal student loans at a more affordable rate. What the bill enacts is tying the interest rate for student loans to the yield on ten-year Treasury notes (See §2(a).3, which approximately works out to be 3.86% for undergraduate students and 5.42% for graduate students). The bill had overwhelming support from Congress, not to mention most Americans, which makes it seem like a good idea. Aside from the fact that these rates don't apply to my own college loans, what could possibly be wrong with maintaining artificially low interest rates for student loans?

Before answering that question, it would be prudent to answer some more important questions: What is the function of an interest rate? Why do lenders need to charge interest rates in the first place? Why not just have Congress mandate that the interest rate be 0% on all loans? Essentially, an interest rate is the cost of borrowing money. The interest rate not only compensates the lender for risk of potential loss on the principal, but it also compensates the lender for having foregone other investments that could have made with those assets. Like any other price, the interest rate relays information to the creditor, which is why the interest rate also takes into account such factors as inflation, length of time of the loan, the consumer's past credit history, as well as the price of the consumer wanting to hasten consumption [as opposed to deferring it]. This is how it is supposed to work, at least when the government doesn't intervene and crowd out the private sector.

The problem is that the government does interfere and does keep the interest rates artificially low, which means that any information that the interest rates were transmitting have been garbled, if not simply lost. With specific regards to the bill, proponents laud the fact that the interest rates on federal student loans are tied to yields on Treasury notes. It might sound nice to have interest rates tied to Treasury notes because "they're attached to 'stable' market forces." In reality, it's no less distortionary to have it tied to Treasury notes than have the government pick some arbitrary interest because guess who's distorting the interest rates on Treasury notes? The Federal Reserve. Using this interest rate as a metric of credit risk is no more informative than what a thirty-day weather forecast would tell me about the weather thirty days from now.

Since the interest is the way a financial institution makes profit, lending at a rate below what an undistorted market would have allowed translates into profit loss. The differential in interest rates means that somebody has to pay for the loss. Our government doesn't have any money of its own and has no concept of making profit, which is why it's in debt (Take a look at a dollar bill. On it, you'll see it says "This note is legal tender for all debts, private and public"). From where does the government accrue its money? The private sector. To pay for the price differential, the federal government either needs to increase tax rates to cover the costs, or it will kick the can down the road by acquiring more debt, thereby increasing the debt-to-GDP ratio. According to the Congressional Budget Office (CBO), the overall student loan program is going to cost the government $90B over the next ten years (Table 2, p. 5).

The average student debt for an individual with an undergraduate education is about $26,000. If you lower the interest from 6.8% to 3.4%, that translates into monthly difference of $44.32 for the individual. While I believe that $44.32 saved is $44.32 earned, this policy distracts people from the more worrisome aspect of financing college education, i.e., college is too expensive to begin with.

When the government sets interest rates below those of the private sector, the government artificially increases demand for a college education because students are now more willing to borrow more money than they would have otherwise. The end result is like any other government subsidy towards education. When demand increases, price also increases. Since colleges now have more consumers [of education], the colleges raise their tuition prices, which cause an upward price spiral in which college costs have increased beyond overall inflation. This only causes more and more student debt, which is exacerbated for those who don't even complete their Bachelor's degree. Even for those who complete their Bachelor's degree, it's hardly a rosy picture. Both the Center for College Affordability (also see here) and the Federal Reserve Bank of New York show that nearly half of college graduates have taken on jobs that do not require a Bachelor's degree (i.e., underemployment). And all of this without getting into credential inflation, which is the idea of the declining value of a Bachelor's degree caused by a decrease in the advantage that a degree holder has [in this case, because of artificially high demand for a college education].

The first step is for the government to stop subsidizing college education because there is evidently an overconsumption of college education. Young adults need to know there are alternatives to the traditional four-year education, whether that is through online/distance learning, technical college, two-year college, apprenticeships, acquiring certifications, starting a business, or directly entering the workforce. Once the postsecondary education marketplace is compelled to compete with alternatives, then we can begin to see a decrease in four-year college tuition prices.

7-7-2015 Addendum: I found another reason for the government to stop subsidizing student loans. For every dollar spent on student loans, the student experiences an average hike of 65 cents on tuition, according to the latest study from the New York Federal Reserve Bank.