Consolidation Loan Borrower Interest Rates (25-FEB-05,
GAO-05-389R).
This 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.
-------------------------Indexing Terms-------------------------
REPORTNUM: GAO-05-389R
ACCNO: A18437
TITLE: Consolidation Loan Borrower Interest Rates
DATE: 02/25/2005
SUBJECT: Education
Interest rates
Lending institutions
Loan interest rates
Student financial aid
Student loans
Subsidies
Financial management
Aid for education
Cost analysis
Federal Family Education Loan Program
William D. Ford Federal Direct Loan
Program
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GAO-05-389R
United States Government Accountability Office Washington, DC 20548
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 costs1 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.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
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.
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).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
4
that underlie consolidation loans. 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.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.
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.
Figure 1: Illustration of Estimated SAP Paid to Holders of FFELP
Consolidation Loans Originated from October to June of Fiscal Year 2006
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.
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
6
the discount rate. 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
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.
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.
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 Change in FFELP Change in FDLP Total
Year Subsidy Costs Subsidy Costs
2006 (166) (71) (238)
2007 (451) (76) (527)
2008 (403) (46) (449)
2009 (361) (16) (377)
2010 (373) (12) (384)
2011 (297) 18 (279)
2012 (186) 45 (141)
2013 (161) 48 (113)
2014 (88) 55 (33)
2015 (100) 57 (43)
Total (2,586) 2 (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.
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
[email protected] or [email protected]. Susan Chin and Chuck Novak were also key
contributors to this letter.
Cornelia M. Ashby
Director, Education, Workforce,
and Income Security Issues
(130454)
*** End of document. ***