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Consequences for Student Financial Aid If Congress Doesn't Raise the Debt Ceiling

Mark Kantrowitz

July 14, 2011

The End of Subsidized Student Loan Interest?

During the ongoing debt negotiations, one side proposed eliminating the subsidized interest on federal student loans. Currently, the federal government pays the interest on subsidized Stafford loans during the in-school and grace periods. Both parties have already proposed eliminating the subsidized interest on loans to graduate and professional students. The new proposal would eliminate the subsidized interest for undergraduate students as well, saving the federal government an additional $4.3 billion a year.

This proposal would have targeted the savings at deficit reduction, continuing a trend that started in 2005, when some of the savings from changes to the student loan programs were redirected at deficit reduction. The Higher Education Reconciliation Act of 2005, the College Cost Reduction and Access Act of 2007 and the Health Care and Education Reconciliation Act of 2010 were all budget reconciliation bills. Budget reconciliation bills are required to reduce the budget deficit. While Congress was able to increase student aid funding by shifting subsidies from lenders to students, they also used billions of dollars of the savings for deficit reduction. For example, the Health Care and Education Reconciliation Act of 2010 used $20 billion of the savings from the switch to 100% Direct Lending for deficit reduction, to ensure passage of the legislation.

Previous proposals to eliminate the subsidized interest benefits have been focused on redirecting the savings toward increases in funding for the Pell Grant program. These changes would yield a more efficient and effective use of student aid funding, since the Pell Grant program is the federal student aid program that is most precisely targeted at financial need. The subsidized interest benefits are not as well targeted, and yield little or no improvements in access to higher education, retention rates or completion rates.

Aside from the amount students can borrow, characteristics of the student loan programs do not have any impact on public policy objectives such as increasing the number of students who enroll in college or who graduate from college. The benefits of subsidized interest and lower interest rates are felt after the student has already graduated. Most students defer paying the interest on their loans while they are in school. So the main difference between a subsidized loan and an unsubsidized loan is in the amount of debt at graduation. There are also adequate safety nets, such as income-based repayment, that can help students who encounter financial difficulty repaying their federal student loans.

If the borrower does not pay the interest on an unsubisidized loan during the in-school and grace periods, the interest is capitalized, adding it to the loan balance. Accordingly, eliminating the subsidized interest would increase the debt at graduation on subsidized loans by about 16%. Since subsidized loans represent about half of debt at graduation, eliminating the subsidized interest would increase debt at graduation by about 8%, assuming a 6.8% interest rate. That increases the cost of a college education, but only after the fact.

But the proposal introduced during the debt ceiling negotiations would have eliminated the subsidized interest benefits without increasing funding for the Pell Grant program. The Pell Grant program would still be left with a funding shortfall and would still be at risk of further funding cuts.

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