lower interest on federal student loans

Lower Interest Rates Won’t Help Many Federal Borrowers

Michael Lux Blog, Student Loans 0 Comments

Many prominent politicians have voiced their support for reducing interest rates on federal student loans, most recently, Hillary Clinton.

On the surface, it seems like an obvious benefit to all borrowers of federal loans.  However, taking a closer look reveals that many different categories of borrowers will not actually benefit from a rate reduction.

The Lost Causes

A number of borrowers have entirely given up on repaying their student loans.  They may have balances so large that they feel they have no chance to ever repay the debt, or they may think their income puts them in a situation that the debt will never be paid off.

For these borrowers, outside of restoring bankruptcy rights to student loans, the federal government can do little to help.  From their perspective, whether the interest rate is 1% or 25%, the loans will not get paid off.

However, if the government did a better job making borrowers aware of different repayment plans and programs, there is a case to be made that more people would benefit.

Income-Driven Borrowers

Many borrowers of federal student loans are on income-driven plans such as IBR, PAYE, and REPAYE.  These plans ensure that borrowers are never required to pay more than a certain percentage of their monthly discretionary income.

One of the major perks of these plans is their eligibility for student loan forgiveness.  Forgiveness can come in two different ways.  First, borrowers who work in public service, such as those working for non-profits or for the government, can qualify for public service forgiveness after 10 years.  Second, regardless of occupation, borrowers on these plans can have their loans forgiven after 20 to 25 years.

A reduced interest rate will simply change how much debt is forgiven for these borrowers.  It will have no bearing on their monthly payments, nor will it affect how soon the loans are forgiven.

The Low Credit Risk Borrowers

Even if the federal government reduced interest rates, they likely would not be able to compete with the top private lenders such as SoFi and CommonBond.  This is because these lenders are targeting the lowest risk federal borrowers, i.e. those with high credit score and high incomes.  These lenders are able to offer rates at around 2% given the high probability of repayment.  The federal government treats all borrowers the same.  This means that the interest rate has to be higher to account for the higher risk levels.  Thus, even a reduced interest rate will still not be enough to keep the business of the most valuable borrowers.

Who does benefit?

One of the biggest beneficiaries will be current students.  Reduced interest rates during school mean that these borrowers will have a smaller balance once the loan enters repayment.

Another beneficiary will be the borrowers who are on the cusp of a number of different student loan routes.  If their balance is not large enough that forgiveness enters the picture, but their income isn’t sufficient to have better options on the private market, a rate reduction could make a huge difference.  These borrowers are often stuck making large payments that are primarily interest and do little to the principal balance.  A reduction of interest rates could lower their payments and/or put them in a situation where the loan can be paid off sooner.

Bottom Line

Lower interest rates on federal student loans sounds like a slam dunk but at the end of the day, the list of people who actually benefit is surprisingly short.