Sen. Kirsten Gillibrand (D-NY) recently introduced the Federal Student Loan Refinancing Act, a piece of legislation that calls for the refinancing of all higher-rate Federal Direct and Federal Family Education (FFEL) student loans at 4% interest. She estimates that her plan will assist nine out of 10 students who borrowed under the various federal education loan programs.
The bill also affects roughly $300 billion of government-backed FFEL student loans, which may have been securitized by companies that had served as conduits for the discontinued program. This move will have a significantly negative impact on investors who participated in these complicated deals — the same folks who have generally resisted providing more than token forbearances to borrowers who are having difficulty making their loan payments.
But here’s the problem: Although moving to 4% interest from the current rate of 6.8% sounds great on paper — a 41% reduction — it doesn’t translate as meaningfully in practice.
For example, say a student exits college with $50,000 in student loan debt. At 6.8% interest, the monthly payment is $575.40. At 4%, the monthly payment would be $506.23 — only 12% lower. (Blame the time value of money formula for the math.)
A better solution would be to restructure the underlying term to 240 months (20 years) from the current 120 (10 years). Doing so would lower the payment to $381.67 or 34% less, without adjusting the original interest rate. Of course, a longer term means more interest paid in due course, which is why it makes sense to permit prepayments at any time, in any amount, without penalty.
And there’s another matter to take into account for any plan that’s intended to help these hopelessly indebted students: affordability.
Say the same $50,000 borrower is single and earns $44,000 per year (the average salary for 2012 bachelor’s degree graduates according to the National Association of Colleges and Employers). Under Gillibrand’s proposal, the revised monthly payment (at 4%) would still consume 14% of his or her pretax monthly salary. That doesn’t leave a lot of room for living expenses — let alone savings — after accounting for the 25% to cover taxes (including Social Security and Medicare), another 25% to 30% for rent, not to mention any other debt payments.
A better solution would be to solve for a monthly payment amount that does not exceed 10% of gross salary (unlike the government’s PAYER program, which is based on discretionary income), so that the same borrower would then be able to comfortably afford payments that run about $370 per month — $12 less than the payment amount of the aforementioned 20-year restructure and $136 less than Sen. Gillibrand’s 4% interest plan.
As important would be to incorporate into any refinancing program the most egregious of these loans: the roughly $150 billion of private borrowing. If Washington is finally willing to take on the complexities of securitized debt, it should also include the often-securitized loans that are dollar-for-dollar more burdensome than any other.
I believe Sen. Gillibrand is on the right track in her attempt to tackle all education loans that involve the federal government, especially if her bill does not discriminate against borrowers who are currently past due or in default — those who most need assistance. My hope, however, is that politicians will set aside their battles over interest rates and ignore the lobbying efforts of those who’ve unfairly benefitted in the past, and instead focus on payment affordability because that’s what’s needed to craft a fair and enduring solution.