By: Rebecca Schultz
If Congress does not start regulating compound interest on student loans, we could be facing our next national financial crisis. Like the mortgage crisis of 2008, when interest rates on mortgages were not being properly managed, negative amortization has led to a situation in which many student-borrowers are incapable of paying off their loans.[1] This enables the existence of situations in which loans are growing so fast that some graduates will never be able to pay them off. This also forces many student-borrowers in government and public-interest work to rely on bailouts by “loan forgiveness” programs and can even incentivize students to choose corporate work instead of a job in public interest.[2] The Public Service Loan Forgiveness Program launched in 2007, and 99% of applicants were denied forgiveness of their loans last year, meaning many borrowers are “plan[ning] their financial lives and careers around it only to discover down the line that they [don’t meet] all of the necessary requirements to qualify for loan forgiveness.”[3] With the impact of compound interest, those growing loans don’t only negatively impact the lives of student-borrowers – they impact the nation too.
THE COST OF COMPOUND INTEREST
Put simply, compound interest is interest on top of interest.[4] Current interest rates for undergraduates using Direct Subsidized Loans and Direct Unsubsidized Loans is 5.05%. The interest rate on Direct Unsubsidized Loans is 6.6% and PLUS Loans is 7.6%. Graduate students are not eligible for federal Subsidized Loans, meaning that graduate student-loans accrue interest (unless you pay the interest during periods of deferment) while they learn.[5] Periods of deferment include the time in which you are enrolled at least half-time at an eligible college or career school, such as being in a graduate program.[6] Being in deferment means you won’t have to make payments on your loans during that time, but for graduate students who are ineligible for subsidized loans, it means your interest is being added to your principal balance and thus your principal balance is growing every day.[7] “The process of adding interest to a loan balance is known as capitalizing the interest.”[8] Capitalization occurs at the end of the deferment or forbearance period.[9]
CONGRESS
Congress sets the interest rates on student loans through the Department of Education.[10] After the passage of the 2010 Student Aid and Fiscal Responsibility Act, Congress voted to set the rates every year, a process which often resulted in a deadlock.[11] While there was much debate over increasing the interest rate on Subsidized Stafford loans from 3.4%, no one discussed the impact of compound interest on raising that base rate.[12] No one discussed the significant impact that length of the loan plays on the final cost of borrowing. If a simple-interest method were used on student loans, student-borrowers would know the actual cost of their education, enabling them to make better financial decisions. However, the current method includes multiple variables. Students don’t know when the price of their tuition will rise, what federal interest rate will be in effect each year, when they will find employment after graduation, or how much they will make in income. At this point, how is any student-borrower supposed to know what their education will cost? And none of this takes any non-tuition variable expenses into consideration.
Why banning compound interest on student loans will benefit everyone:
Forbes reported that, “Student loan debt is now the second highest consumer debt category – behind only mortgage debt – ”.[13] The Department of Education is currently profiting from defaulted loans.[14] According to the New York Post, student debt is “careening toward $2 trillion within the next three years,”.
Compare that with the fact that in March 2007, the value of subprime mortgages was estimated at $1.3 trillion. Bloomberg has considered this issue and thinks that the collapse of housing prices forced students to take out more loans to fund their educations.[15] Bloomberg thinks that this isn’t due to any major increase in the number of people who attend college or the net tuition at public four-year universities,[16] but tuition and the number of students has risen since 2007. And when tuition rises, compound interest has more to eat; your loans don’t just grow – they grow at faster rates.
Lowering the face value of tuition at most colleges might not be a feasible task when schools are aiming to educate in a modern economy, which requires certain expensive technologies and equipment.[17] It doesn’t make sense to divest the funding of education, but it does make sense to make sure that we can continue to provide valuable education—to progress and grow our economy—to the students who are willing to foot the bill. By instituting safer interest regulations on student-loans, such as banning compound interest, Congress can ensure that those loans can be paid in full and avoid another financial crisis.
[1] Justin Pritchard, Negative Amortization Loans, The Balance (last visited Dec. 3, 2018), https://www.thebalance.com/negative-amortization-loans-315689. “Negative amortization happens when the payments on a loan are not large enough to cover the interest costs.” Amortization tables illustrate the way in which one can make fixed payments each month that cover changing ratios of interest to debt. When someone makes less than the “fully amortizing” payment on their loan each month, interest costs are added to your loan balance, and you end up owing more money every month. If a graduate-borrower can follow amortization by making the full payment every month, they can know the true monetary value of their education. However, this value is premised on the idea that one will not make any less than the required amount, something which gets harder to do every time you fail to make a full payment.
[2] Public Service Loan Forgiveness, Federal Student Aid (last visited Dec. 3, 2018), https://studentaid.ed.gov/sa/repay-loans/forgiveness-cancellation/public-service; Adina Appelbaum, Should You Become a Public Interest Lawyer?, Above the Law (Jul. 21, 2017), https://abovethelaw.com/career-files/should-you-become-a-public-interest-lawyer/ (stating that “a public interest salary can present financial stress and uncertainty, particularly if you live in a big city”).
[3] Jordan Weissmann, There’s Supposed to be a Student Loan Forgiveness Program for Public Servants. So Far, It’s Rejected Almost Every Applicant, Slate (Sep. 26, 2018), https://slate.com/business/2018/09/public-service-loan-forgiveness-program-applicant-rejections.html.
[4] Troy Segal, Compound Interest, Investopedia (last visited Dec. 3, 2018) https://www.investopedia.com/terms/c/compoundinterest.asp.
[5] Interest Rates and Fees: Understand How Interest is Calculated and What Fees are Associated With Your Federal Student Loan, Federal Student Aid (last visited Dec. 3, 2018), https://studentaid.ed.gov/sa/types/loans/interest-rates.
[6] Interest Rates and Fees: Understand How Interest is Calculated and What Fees are Associated With Your Federal Student Loan, Federal Student Aid (last visited Dec. 3, 2018), https://studentaid.ed.gov/sa/types/loans/interest-rates.
[7] Interest Rates and Fees: Understand How Interest is Calculated and What Fees are Associated With Your Federal Student Loan, Federal Student Aid (last visited Dec. 3, 2018), https://studentaid.ed.gov/sa/types/loans/interest-rates.
[8] Justin Pritchard, Negative Amortization Loans, The Balance (last visited Dec. 3, 2018), https://www.thebalance.com/negative-amortization-loans-315689.
[9] Deferment and Forbearance: A Deferment or Forbearance Allows You to Temporarily Stop Making Your Federal Student Loan Payments or to Temporarily Reduce the Amount You Pay, Federal Student Aid (last visited Dec. 3, 2018), https://studentaid.ed.gov/sa/repay-loans/deferment-forbearance.
[10] Craig Anthony, Who Sets Interest Rates for Federal Student Loans, Investopedia (July 23, 2016), https://www.investopedia.com/ask/answers/072316/who-sets-interest-rates-federal-student-loans.asp.
[11] Dave Rathmanner, Current Student Loan Interest Rates, Lendedu (Jan 5, 2017), https://lendedu.com/blog/student-loan-interest-rates#tab-con-6. This is a near quote from a website I found. Is that okay?
[12] Keeping College Within Reach: The Role of Federal Student Aid Programs: Hearing before the Subcommittee on Higher Education and Workforce Training, Committee on Education and the Workforce, House of Representatives, 113th Cong. 31 (2013), (statement of Moriah Miles, State Chair, Minnesota State University Student Association), https://www.gpo.gov/fdsys/pkg/CHRG-113hhrg80339/pdf/CHRG-113hhrg80339.pdf.
[13] Zack Friedman, Student Loan Debt In 2017: A $1.3 Trillion Crisis, Forbes (Feb. 21, 2017), https://www.forbes.com/sites/zackfriedman/2017/02/21/student-loan-debt-statistics-2017/#35bce7435dab.
[14] Dept of Education Profiting on Defaulted Student Loans, Daily Kos (Jan. 6, 2011), https://www.dailykos.com/stories/2011/1/6/933809/- ; Janet Lorin, Who’s Profiting From $1.2 Trillion of Federal Student Loans?, Bloomberg (Dec. 11, 2015), https://www.bloomberg.com/news/articles/2015-12-11/a-144-000-student-default-shows-who-profits-at-taxpayer-expense.
[15] Dave Rathmanner, Here’s Why Student Loan Debt is So High – and What it’s Doing to the Economy, Lendedu (Apr. 4, 2018), https://lendedu.com/news/heres-why-student-loan-debt-is-so-high-and-what-its-doing-to-the-economy/ ; Noah Smith, The Financial Crisis Isn’t Over for Students, Bloomberg Opinion (last visited Dec. 3, 2018), https://www.bloomberg.com/opinion/articles/2018-03-27/financial-crisis-is-over-for-housing-but-not-for-student-loans.
[16] Noah Smith, The Financial Crisis Isn’t Over for Students, Bloomberg Opinion (last visited Dec. 3, 2018), https://www.bloomberg.com/opinion/articles/2018-03-27/financial-crisis-is-over-for-housing-but-not-for-student-loans (stating that “Average net tuition at public four-year universities, for example, rose from $7,280 in the 2007-08 year to $9,970 in 2017-18 – – an increase of 37 percent.”). 37% is a significant increase in tuition, and about forty percent of the $1 trillion national student debt was used to finance graduate and professional degrees, not four-year public universities. See A Look at the Shocking Student Loan Debt Statistics for 2018, Student Loan Hero, (last visited Dec. 3, 2018), https://studentloanhero.com/student-loan-debt-statistics/ and https://www.newamerica.org/education-policy/policy-papers/the-graduate-student-debt-review/.
[17] The Rising Costs of a U.S. College Education, PwC-KWHS (Mar. 15, 2018), http://kwhs.wharton.upenn.edu/2016/03/the-rising-costs-of-a-college-education/.