On July 1, interest rates on new federal student loans doubled from 3.4% to 6.8%.
Politicians in both parties say they want to fix the interest rate jump, but they can’t agree on exactly how to do so.
Student loan balances have soared over the last decade, even as other kinds of consumer debt have declined. Students have been borrowing more and more to cover rapidly rising tuition.
The student debt burden is a key factor slowing the recovery: Young professionals, burdened with student loans, cannot afford to buy homes and take out mortgages.
Higher interest rates will further exacerbate that problem.
Here, we’ll take a look at why student loan debt has grown and how different politicians propose to provide relief.
Student debt is the only kind of household debt that rose during the recession. It's now the second-largest consumer debt category after mortgages.
Debt is growing mostly because the cost of college is growing. This chart from the centre for College Affordability and Productivity shows how tuition has risen meteorically: Almost twice as fast as health care costs since 1980.
Increasingly, former students are having trouble paying their loans. In the past several quarters, student loans have the highest delinquency rate of any loan type.
But students keep taking out loans anyway, and for pretty good reasons: College degrees are more valuable than ever for raising your earning potential and reducing your likelihood of being unemployed.
Unlike other kinds of debt, most student loans are subsidized by the federal government and their rates set by law. Over the last few years, Treasury bond rates have fallen sharply and that has made it cheaper to borrow through vehicles like mortgages and credit cards. But Congress has to change the student loan rate manually to keep up. A 2007 law cut student loan rates over a period of several years, but it expired in July, which caused rates to shoot back up.
Most of the new proposals would tie student loan rates to Treasury bond rates, which would mean low rates now.
There are four competing proposals in Congress for the student loan impasse, all of which would set rates well below 6.8%
President Obama proposes fixed-rate loans tied to 10-year Treasury bond rates. Today, interest rates would be 3.58%, very close to the law before July 1.
Like Obama's plan, House Republicans want to tie student loan interest rates to the 10-year Treasury bond, but with two key differences. They want to charge students a higher interest rate spread over Treasuries to compensate the government more for the risk of non-payment. And they propose a floating rate, which means that if interest rates go up, students would start paying more on their already outstanding loans, up to a cap of 8.5%. Under Obama's plan, rising Treasury rates would only mean higher interest on new loans.
Sens. Jack Reed (D-R.I.) and Dick Durbin (D-Ill.) have their own floating rate plan which would work off the 3-month Treasury bill. Short term interest rates are currently close to zero, so this plan would actually sharply cut interest rates on new student loans, likely to about 2%. But like the Republicans' plan, the interest rate would float up to a cap, and since 3-month interest rates move a lot faster than 10-year rates, students could be hit with sudden interest rate increases in the future.
Sen. Elizabeth Warren has the most radical plan, setting student loan interest rates at just 0.75% this year. This isn't likely to pass.
While lower interest rates will save students money, conservative critics note that they don't address the underlying driver of rising student loan debt: rapidly rising tuition. In fact, by giving out subsidized loans, the federal government makes it easier for colleges to raise prices. A recent report from the Manhattan Institute recommends limiting subsidized federal loans to the average tuition within a given college sector, so students are encouraged to choose cheaper schools and the most expensive public and private colleges have more difficulty raising tuition.
Regardless of the interest rate fix, student loan debt is likely to continue exploding unless the underlying tuition problem is fixed.
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