Consolidation Loan Borrower Interest Rates
Gao ID: GAO-05-389R February 25, 2005This letter responds to a question from the Chairman, House Committee on Education and the Workforce, related to the recommendation we made in our October 31, 2003, report Student Loan Programs: As Federal Costs of Loan Consolidation Rise, Other Options Should Be Examined (GAO-04-101), which we completed at the Chairman's request. We reported that then recent trends in interest rates and consolidation loan volumes had affected the federal costs of consolidations in the Department of Education's two major student loan programs--the Federal Family Education Loan Program (FFELP) and the William D. Ford Federal Direct Loan Program (FDLP)--in different ways, but in the aggregate, estimated federal subsidy costs for consolidation loans had increased. In light of these increased costs, we recommended in our report that the Secretary of Education assess the advantages of consolidation loans for borrowers and identify options for reducing federal costs, taking into consideration how best to distribute program costs among borrowers, lenders, and the taxpayers. Among the options we suggested for the Secretary's consideration was changing the borrower interest rate on consolidation loans from a fixed to a variable rate. Given that some time has passed since we issued our report, the Chairman asked for our perspective on whether economic circumstances--such as current and projected interest rates--are such that a variable interest rate remains a viable option for reducing federal costs of student consolidation loans. On the basis of the information discussed below, we believe a variable interest rate remains a viable option for reducing federal costs.
The Department of Education's proposal to change from a fixed to a variable rate the interest charged to borrowers on consolidation loans, as well as its other consolidation loan reform proposals included in the President's Budget for Fiscal Year 2006, is consistent with the recommendation we made in our October 31, 2003, report that the Secretary of Education identify options for reducing federal costs.
GAO-05-389R Consolidation Loan Borrower Interest Rates
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February 25, 2005:
The Honorable John A. Boehner:
Chairman:
Committee on Education and the Workforce:
House of Representatives:
Subject: Consolidation Loan Borrower Interest Rates:
This letter responds to your question related to the recommendation we
made in our October 31, 2003, report Student Loan Programs: As Federal
Costs of Loan Consolidation Rise, Other Options Should Be Examined (GAO-
04-101), which we completed at your request. As you know, we reported
that then recent trends in interest rates and consolidation loan
volumes had affected the federal costs of consolidations in the
Department of Education's two major student loan programs--the Federal
Family Education Loan Program (FFELP) and the William D. Ford Federal
Direct Loan Program (FDLP)--in different ways, but in the aggregate,
estimated federal subsidy costs[Footnote 1] for consolidation loans had
increased. In light of these increased costs, we recommended in our
report that the Secretary of Education assess the advantages of
consolidation loans for borrowers and identify options for reducing
federal costs, taking into consideration how best to distribute program
costs among borrowers, lenders, and the taxpayers. Among the options we
suggested for the Secretary's consideration was changing the borrower
interest rate on consolidation loans from a fixed to a variable
rate.[Footnote 2] Given that some time has passed since we issued our
report, you asked for our perspective on whether economic
circumstances--such as current and projected interest rates--are such
that a variable interest rate remains a viable option for reducing
federal costs of student consolidation loans. On the basis of the
information discussed below, we believe a variable interest rate
remains a viable option for reducing federal costs.
VARIABLE BORROWER INTEREST RATE FOR CONSOLIDATION LOANS IS A VIABLE
OPTION FOR REDUCING FEDERAL SUBSIDY COSTS:
Changes in market interest rates affect the costs of the FFELP and FDLP
in different ways due to differences between how the programs operate.
Under FFELP, private lenders make loans to students, with Education
guaranteeing the lenders loan repayment and a rate of return on the
loans they make. Under FDLP, the federal government makes loans to
students using federal funds. A change in the borrower interest rate on
consolidation loans from a fixed to a variable rate would affect
federal subsidy costs for FFELP and FDLP consolidation loans in the
ways discussed below.
FFELP:
As we previously reported, increased federal subsidy costs of FFELP
consolidation loans were due in part to the fact that the government-
guaranteed rate of return to lenders was projected to be higher than
the fixed interest rate consolidation loan borrowers pay. When the
interest rate paid by borrowers does not provide the full guaranteed
rate to lenders, the federal government must pay lenders the
difference--an interest subsidy called a special allowance payment
(SAP).[Footnote 3] If the borrower's rate exceeds the guaranteed lender
yield, Education does not pay a SAP, and the lender receives the
borrower rate. As was the case when we issued our prior report, the
Administration currently projects that interest rates and the
guaranteed lender yield will continue to rise over the next several
years. As a result, in future years, when the guaranteed lender yield
is expected to increase, Education would have to make up any difference
between the higher lender yields and the fixed rate paid by current
consolidation loan borrowers.
Since we issued our report, Education has developed several proposals,
presented in the President's Fiscal Year 2006 Budget, that are intended
to reduce federal costs of consolidation loans, including the
introduction of a variable borrower interest rate. The proposal would
replace the current fixed rate interest formula for consolidation loans
with the variable rate formula currently used for Stafford student
loans--loans that underlie consolidation loans.[Footnote 4] The
interest rates that borrowers currently pay on Stafford loans adjust
annually, based on a statutorily established market-indexed rate
setting formula, and may not exceed 8.25 percent.[Footnote 5] Figure 1
shows how, when interest rates are projected to increase in the future,
a change to a variable borrower interest rate would reduce federal SAP
costs for FFELP consolidation loans originated in fiscal year 2006.
Figure 1: Illustration of Estimated SAP Paid to Holders of FFELP
Consolidation Loans Originated from October to June of Fiscal Year
2006:
[See PDF for image]
Note: The estimated lender yield and variable borrower interest rate do
not vary after fiscal year 2011 because the Administration's interest
rate projections do not vary after fiscal year 2011. The estimated
fixed borrower rate is for a consolidation loan originated from October
to June of fiscal year 2006, whose underlying loans are Stafford loans
disbursed after July 1, 1998, and in repayment at time of
consolidation. Under current law, borrower rates on Stafford loans are
scheduled to become a fixed rate of 6.8 percent on July 1, 2006.
[End of figure]
As the figure shows, based on current interest rate projections,
lenders would receive a SAP in fiscal year 2006 and beyond for
consolidation loans made in fiscal year 2006. The amount of the SAP
would be determined based on the difference between the lender's yield
and the borrower interest rate and the amount of the consolidation
loan. As the figure also shows, the difference, or spread, between the
lender yield and the variable borrower interest rate proposed by
Education is less than the spread between the lender yield and the
fixed borrower interest rate. This is due to the fact that, as interest
rates rise in the future, the variable borrower rate would increase
along with the lender yield. As a result, federal SAP costs would be
reduced. The amount by which SAP costs would be reduced would be
determined by the difference between the fixed borrower rate and the
variable borrower rate shown above. If market interest rates were to
decline, rather than increase as projected, SAP cost reductions would
be smaller because the spread between the projected variable and fixed
borrower interest rates would decrease. Further, if market interest
rates were to decline to the point that a variable borrower rate would
be less than the fixed rate shown, SAP would continue to be paid on
loans with a variable interest rate, but would not be necessary for
loans with the fixed rate shown.
FDLP:
We also previously reported that, as a direct loan program, the FDLP
consolidation program involves no guaranteed yields to private lenders
and the subsidy cost of this program is determined in part by the
relationship between the interest rate Education earns from borrowers-
-the borrower rate--and the rate Education pays Treasury to finance its
lending. The government's cost of capital is determined by the interest
rate Education pays Treasury to finance direct student loans, which is
equivalent to the discount rate.[Footnote 6] When the borrower rate is
greater than the discount rate, Education receives more interest from
borrowers than it pays to Treasury. In calculating the subsidy costs of
FDLP loans made in a given year, the discount rate is generally fixed
for the life of the loans. Because current borrower interest rates on
consolidation loans are also fixed, the subsidy costs of FDLP
consolidation loans made in a given fiscal year do not vary in the way
the subsidy costs for FFELP consolidation loans do. However, changing
the borrower rate from a fixed to a variable rate would affect the
subsidy costs of FDLP consolidation loans. Figure 2 shows the
relationship, for a FDLP consolidation made in fiscal year 2006,
between the discount rate, a fixed borrower interest rate, and a
variable borrower interest rate based on the Administration's interest
rate projections.
Figure 2: Illustration of Assumed Discount Rate and Fixed-and Variable
Borrower Interest Rates on a FDLP Consolidation Loan Originated from
October to June of Fiscal Year 2006:
[See PDF for image]
Note: The estimated variable borrower rate does not vary after fiscal
year 2011 because the Administration's interest rate projections do not
vary after fiscal year 2011. The estimated fixed borrower rate is for a
consolidation loan originated from October to June of fiscal year 2006
and whose underlying loans are Stafford loans disbursed after July 1,
1998, and in repayment at time of consolidation. Under current law,
borrower rates on Stafford loans are scheduled to become a fixed rate
of 6.8 percent on July 1, 2006.
[End of figure]
As figure 2 shows, based on current interest rate projections, the
discount rate is projected to be less than the fixed borrower rate for
a consolidation loan made in fiscal year 2006. As a result, Education
would receive more interest from borrowers than it would pay in
interest to Treasury. As figure 2 also shows, the spread between the
discount rate and the variable borrower rate the Administration
proposes would result in Education receiving an even greater amount of
interest from borrowers, thereby decreasing the subsidy cost of, or
increasing the gain to the government from, an FDLP consolidation loan.
If, however, market interest rates were to decline, rather than
increase as projected, a variable borrower rate would also decline,
resulting in Education receiving less interest from borrowers than
shown above. If interest rates declined below the discount rate, such a
scenario could result in Education paying more in interest to Treasury
than it receives from borrowers.
ADMINSTRATION ESTIMATES THAT A VARIABLE BORROWER RATE WOULD RESULT IN
SAVINGS OF $2.6 BILLION OVER FISCAL YEARS 2006-2015:
The proposal in the President's Budget for Fiscal Year 2006 to replace
the current fixed-rate interest formula for consolidation loans with a
variable rate formula is one of several proposals in a package of
proposed changes for the consolidation loan program designed to reduce
overall program costs. Compared to its baseline estimates of FFELP and
FDLP subsidy costs, which assume no changes are made in the loan
programs, the Administration estimates that implementing a variable
borrower interest rate would reduce subsidy costs by about $2.6 billion
for consolidation loans originated in the 2006-2015 period. The
Administration's estimates of the change in estimated subsidy costs for
both FFELP and FDLP consolidation loans, by fiscal year, are shown in
table 1.
Table 1: Change in Estimated Costs of Consolidation Loans from
Implementing:
Variable Borrower Interest Rate Proposal, by Program and Fiscal Year ($
in millions):
Fiscal Year: 2006;
Change in FFELP Subsidy Costs: (166);
Change in FDLP Subsidy Costs: (71);
Total: (238).
Fiscal Year: 2007;
Change in FFELP Subsidy Costs: (451);
Change in FDLP Subsidy Costs: (76);
Total: (527).
Fiscal Year: 2008;
Change in FFELP Subsidy Costs: (403);
Change in FDLP Subsidy Costs: (46);
Total: (449).
Fiscal Year: 2009;
Change in FFELP Subsidy Costs: (361);
Change in FDLP Subsidy Costs: (16);
Total: (377).
Fiscal Year: 2010;
Change in FFELP Subsidy Costs: (373);
Change in FDLP Subsidy Costs: (12);
Total: (384).
Fiscal Year: 2011;
Change in FFELP Subsidy Costs: (297);
Change in FDLP Subsidy Costs: 18;
Total: (279).
Fiscal Year: 2012;
Change in FFELP Subsidy Costs: (186);
Change in FDLP Subsidy Costs: 45;
Total: (141).
Fiscal Year: 2013;
Change in FFELP Subsidy Costs: (161);
Change in FDLP Subsidy Costs: 48;
Total: (113).
Fiscal Year: 2014;
Change in FFELP Subsidy Costs: (88);
Change in FDLP Subsidy Costs: 55;
Total: (33).
Fiscal Year: 2015;
Change in FFELP Subsidy Costs: (100);
Change in FDLP Subsidy Costs: 57;
Total: (43).
Total;
Change in FFELP Subsidy Costs: (2,586);
Change in FDLP Subsidy Costs: 2;
Total: (2,584).
Source: Department of Education.
Notes:
These estimated savings are based on the assumption that several
Administration policy proposals concerning student loans are enacted.
Because certain proposals may impact others, these estimated savings
may vary depending on the specific proposals enacted.
Totals may not add due to rounding.
We did not examine the reasonableness of the Administration's estimates.
[End of table]
As shown in table 1, the estimated savings over the 10-year period
would vary by program and fiscal year. Actual savings will be affected
by a number of factors, including the extent to which forecasted
interest rates vary from actual interest rates. Additional factors
include the extent to which actual consolidation loan volume and
characteristics of loans underlying consolidation loans, and rates of
loan repayment and default vary from assumptions Education used in
making its estimates.
In closing, the Department of Education's proposal to change from a
fixed to a variable rate the interest charged to borrowers on
consolidation loans, as well as its other consolidation loan reform
proposals included in the President's Budget for Fiscal Year 2006, is
consistent with the recommendation we made in our October 31, 2003,
report that the Secretary of Education identify options for reducing
federal costs.
In providing updated information for this letter, we reviewed the
President's Budget for Fiscal Year 2006, obtained and reviewed
additional information from Education concerning the assumptions used
in preparing the President's budget and the Administration's student
loan program policy proposals, and interviewed knowledgeable Education
officials. We conducted our work in February 2005 in accordance with
generally accepted government auditing standards. We provided Education
with a copy of our draft letter for review and comment. Education
provided a technical comment, which we incorporated.
As agreed with your office, unless you publicly announce its contents
earlier, we plan no further distribution of this letter until 30 days
after its date. At that time, we will send copies of this letter to the
Secretary of Education and other interested parties. The letter will
also be available on GAO's home page at http://www.gao.gov. If you have
any questions about this letter, please contact me at (202) 512-8403 or
Jeff Appel, Assistant Director, at (202) 512-9915. You may also reach
us by e-mail at ashbyc@gao.gov or appelc@gao.gov. Susan Chin and Chuck
Novak were also key contributors to this letter.
Signed by:
Cornelia M. Ashby:
Director, Education, Workforce, and Income Security Issues:
(130454):
FOOTNOTES
[1] Subsidy costs are the net present value of cash flows to and from
the government, excluding administration costs, that result from
providing loans to borrowers.
[2] The borrower interest rate on consolidation loans is currently
calculated as the weighted average of the interest rates in effect on
the loans being consolidated rounded up to the nearest one-eighth of 1
percent, capped at 8.25 percent.
[3] The SAP is based on a formula specified in law and paid by
Education to lenders on a quarterly basis when the "guaranteed lender
yield" exceeds the borrower rate. This guaranteed lender yield is
currently based on the average 3-month commercial paper interest rate
plus 2.64 percent. The amount of quarterly SAP paid to loan holders
equals the difference between the guaranteed lender yield and the
borrower rate divided by 4 and multiplied by the average unpaid
principal balance for all loans the lender holds.
[4] Borrowers may also consolidate other types of student loans,
including PLUS loans, Perkins loans, Health Professions Student Loans,
Nursing Student Loans, and Health Education Assistance Loans.
[5] For Stafford loans originated between July 1, 1998 and June 30,
2006 the borrower interest rate is the bond equivalent rate of the 91-
day Treasury bill at the final auction held prior to June 1 (rates
become effective July 1 through the following 12-month period) plus 1.7
percent during in-school, grace, and deferment periods and 2.3 percent
during repayment periods, capped at 8.25 percent. Under current law,
borrower rates on Stafford loans are scheduled to become a fixed rate
of 6.8 percent on July 1, 2006. Among the Administration's other
student loan program proposals is one to retain the variable borrower
interest rate on Stafford loans.
[6] While the discount rate is the interest rate used to calculate the
present value of the estimated future cash flows to determine subsidy
cost estimates, it is also generally the same rate at which interest is
paid by Education on the amounts borrowed from Treasury to finance the
direct loan program.
