Is Uncle Sam Earning Interest On Student Loans?

Short Answer: Not really.

Long Answer: It’s complicated.

A common phrase that people use when talking about the student debt crisis is “well, at least Uncle Sam is earning interest on the student loans.”

But this isn’t really truthful.

Obviously, the student loan program was not originally designed to be an income-generator. It was designed as a means for individuals to get college education subsidized.

But, with a program like that comes cost.

If the government did not have some interest on the student loans given out to students, the cost would quickly become astronomical.

Case study: The United Kingdom.

Take this from the Brooking Institute, which analyzed Britain’s “free college” (more aptly called taxpayer-funded):

Until 1998, full-time students in England could attend public universities completely free of charge. But concerns about declining quality at public institutions, government mandated caps on enrollment, and sharply rising inequality in college attainment led to a package of reforms which began in 1998, including the introduction of a modest tuition fee.

Two decades later, most public universities in England now charge £9,250—equivalent to about $11,380, or 18 percent more than the average sticker price of a U.S. public four-year institution.

The typical English bachelor’s degree recipient is now expected to graduate with around £44,000 (approximately $54,918) in student loan debt, more than twice the average for graduates who borrow at U.S. four year institutions.

Many other countries with similar structures face similar problems. They have to “mandate caps on enrollment” to not go fully into the state-sponsored debt spiral which leads down into the financial abyss.

Thus, interest on student loans.

The government gives them out with expectations that they will be repaid, and the loan will accumulate interest on it to offset the massive costs of giving these loans out.

What costs am I talking about on student loans?

Where do the costs come from?

Many places, but most notably:

• Inflation – money lent today is worth more than money received tomorrow, due to inflation.
• The massive risk is that more students will fall behind/default on their loans. (And thus, no return of the loan).
• Administrative costs.

And these costs are not small.

A quick check on inflation shows that just over 5 years resulted in this change:

In other words, $100 in 2010 is equivalent in purchasing power to $108.70 in 2015, a difference of $8.70 over 5 years.

Now check that number in billions:

In other words, $100,000,000,000 in 2010 is equivalent in purchasing power to $108,695,472,722.60 in 2015, a difference of $8,695,472,722.60 over 5 years.

Now consider that Americans own more than 1.3 trillion in student debt. That’s where these numbers quickly get astronomical and dangerous. Especially when considering these inflationary pressures.

And most student loans are not paid off in only 5 years. Some stretch as long as 20. For the unfortunate (unintelligent?) few who took out catastrophically sized loans, maybe even a lifetime.

Inflation doesn’t care about that. It still comes and eats at the government’s returns, regardless.

And the government returns are your current (or future) tax dollars, hard at work.

The interest that the government charges on most of their student loans is government-mandated below market rate. Meaning, the market would actually result in a much higher interest rate, due to default risk.

This is easily seen by looking at private companies offering loans at interest rates sometimes double or triple the rate of federal subsidized loans.

Next up, let’s consider default.

Many statisticians utilize certain methods to measure the risk of default. They usually compare loans to other similar loans, such as a car loan or a mortgage.

This isn’t an accurate method, however, as even the CBO argues.

This is because the default rate for student loans is significantly higher than other types of debt. The Brookings Institute anticipates a 40% default rate by 2023.

That means all the money that the government loaned out will not be coming back in. With or without interest.

Which means the individuals that DO pay their loans are subsidizing the losers that don’t.

In An Ideal World

In a perfect world, interest would account for:

1. exact inflation, post-marked for the previous year
2. Slight profit needed to cover reasonable administrative costs

But this is not possible because of that risk of default. Because so many people default on their financial obligations, the rate needs to be higher to adjust for that risk.

And that risk is under-valued because the interest rates for student loans are below the market rate, and are government-set without allowing for budgeting increases. Since default is so common, the government tends to lose money when accounting for all expenses incurred.

The degree of subsidy for federal loans depends a lot on the year you’re looking at. 2010, for example, showed the government losing money, while 2013 showed a profit. The numbers also don’t take administrative costs into account:

Some years fair value shows profit on some loans, but even CBO off the record doubts those profits due to “overly optimistic” doe collection rates. In 2010, fair value showed big subsidies, 2013 showed very small profit, but did not include administrative costs. Again, depends on the year.

On top of that, many loans cover the interest on the loan as long as the borrower is still in school. Which is an additional expense. The interest doesn’t just “go away”, someone has to take the hit for inflation. And the government does precisely that:

Subsidized loans are available for low-income students, and can’t be used on more than $5,500 a year in tuition and other costs, and can’t accumulate to more than $23,000 in debt total. Those carry an interest rate of 3.4 percent, and the government pays the interest on the loan as long as the borrower’s in school.

CBO can clear some of this up sufficiently:

Just like any institution, the CBO determines the cost of loans by “discounting all of the expected future cash flows associated with the loan or loan guarantee—including the amounts disbursed, principal repaid, interest received, fees charged and net losses that accrue from defaults—to a present value at the date the loan is disbursed.” To do that, it needs to settle on a “discount rate,” which is usually the expected rate of return on the loan in question. Banks and other private institutions generally estimate that by finding loans with similar risks and maturities to the one being evaluated, and then using those similar loans’ rates of returns.

The CBO does not do that. It discounts all government loans using the returns on Treasuries of similar maturity. So a 30-year student loan would be compared to a 30-year Treasury bond. But Treasuries are the safest bonds in the world. The U.S. government does not have a very high risk of defaulting, not least since it prints its own money. Student loans are much, much riskier. The default rate at four-year public colleges and universities is around 4 to 5 percent. To capture the true risk of these loans, you’d need to discount using the rate of return for another loan with similar risk. Comparing them to Treasuries make them seem safe no matter what the actual risk.

But the CBO itself says there is a better way to calculate the money coming in and out of the loan program, which accounts for the risk that more students will fall behind or default on their loans than originally thought. So while the official estimate goes in the federal budget, the agency publishes both projections.

By that measure, the loan program would result in a loss for Uncle Sam — and not an insignificant amount. It shows the government would lose about $20.6 billion this year, and would continue to lose money over the next decade.

The two estimates are so widely different because there’s no way to know the exact cost of loans given out in one year until it’s fully paid off — and that could take 40 years, according to a report from the Government Accountability Office.

That means they have to make guesses about how fast students can pay back the loans, how many will defer payments while they go to grad school or look for work, and how many will default.

There’s a lot of risk in student loans, said Jason Delisle, an expert on student loan programs and Fellow at the American Enterprise Institute, a conservative think tank. The government offers loans to students at accredited colleges, with very few questions asked. It doesn’t check on your credit score, there’s no collateral, and there’s [currently] a 25% default rate, Delisle said.

No matter which way you do the math, the loans offered to undergraduate borrowers do not make money for the government. Any profit comes from loans made to graduate students and parents, which charge higher interest rates.

Admin costs

Many estimates of the student loan cost ignore administrative costs, which the CBO estimates at $35 billion over 10 years.

There need to be managers, account balances, contract specialists, and a plethora of other individuals to get that money to schools efficiently and fluently.

This adds to the cost, and the necessity for interest on the loans. It makes little sense to assume that a government could give out a loan for free, take the money back, and be back at square one without any cost incurred, whether through inflation or admin costs.

Conclusion

Some years, Uncle Sam may make some money on student loans. Other years, he may take a big hit.

The profit years help subsidize the non-profit years. Just the same as the interest rate helps subsidize the inflation and default rate.

Most estimates indicate that long-term, the government will lose money on student loans. It is a cost center, not a profit center. The short and medium term is not always so clear cut.

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