Dealing with the Debt Deal and Downgrade: Practical Tips for Students and their Families - Fastweb

Dealing with the Debt Deal and Downgrade: Practical Tips for Students and their Families

Mark Kantrowitz

August 08, 2011

Title: Dealing with the Debt Deal and Downgrade: Practical Tips for Students and their Families

Standard & Poor’s (S&P) downgraded US long-term debt one notch from AAA to AA+ after the stock market closed on Friday, August 5, 2011. This is the first time the United States has lost its AAA rating. The downgrade triggered a panic sell-off when the stock market reopened on Monday, August 8, 2011, with the Dow Jones Industrial Average closing down 634 points (5.5%) to end at 10,809.85. This is the biggest one-day drop since December 2008 and the sixth-biggest drop ever.

Despite the downgrade in US debt, investors paradoxically flocked to US Treasuries, since US debt remains one of the most liquid and safest forms of sovereign debt. Prices and yields on bonds move in opposite directions, so the greater demand for US bonds caused interest rates on the debt to drop by almost a quarter of a percentage point.

Increase in Interest Rates Likely

Nevertheless, interest rates on US debt are likely to increase by 0.25% to 0.50% in a few weeks, after the panic reaction eases.

Increases in the interest rates on US Treasuries will probably stimulate increases in the LIBOR index and Prime Lending Rate. These indexes aren’t directly tied to interest rates on US debt, but are heavily influenced by the prevailing interest rates.

The LIBOR index and Prime Lending Rate will increase even more during the economic recovery over the next 5-6 years. At the start of the credit crisis the LIBOR index dropped by 5.5%. It can just as easily increase by 5.5% or more during the economic recovery. While the LIBOR index dropped by 5.5% over a two-year period at the start of the credit crisis, it will probably increase by that amount over a four-year period, if it follows historical patterns.

Most private student loans have variable rates that are pegged to the LIBOR index or Prime Lending Rate. So interest rates on variable rate private student loans will probably start increasing soon, and then continue to increase over several years. This will affect the interest rates on both existing and new private student loans.

Federal education loans have had fixed interest rates since July 1, 2006, so existing federal education loans will not be affected by any increase in Treasury rates. Instead, the increase in the government’s cost of funds will reduce the profit the government earns on these loans. The profits on federal education loans are used to fund other student aid programs and for deficit reduction.

The increase in federal borrowing costs and the need to cut the budget deficit will yield a bias in Congress toward increasing interest rates on new federal education loans. For example, the College Cost Reduction and Access Act of 2007 enacted a temporary phased-in interest rate reduction on subsidized Stafford loans to undergraduate students. The fixed interest rate dropped from 6.8% in 2007-08 to 6.0% in 2008-09, 5.6% in 2009-10, 4.5% in 2010-11 and 3.4% in 2011-12. If Congress does not act, new loans in 2012-13 and beyond will return to the original 6.8% interest rate. Congress is unlikely to pass legislation to extend the 3.4% interest rate.

Another example is in the elimination of the subsidized interest benefit on subsidized Stafford loans to graduate and professional students. Despite opposition from President Obama, Congress is likely to eliminate the subsidized interest benefit for undergraduate students in order to reduce the budget deficit.

So even if Congress doesn’t proactively increase the interest rate on student loans, there are many ways Congress could pass on increased costs to students and their families.

Other Student Aid Programs Remain at Risk of Cuts

The need to cut the budget deficit will also put other student aid programs at risk of being cut. Student aid is just too big a target for Congress to allow it to survive unscathed. The SEOG, LEAP and Federal Work-Study programs are all at risk of being cut. Similarly, the education tax benefits — Hope Scholarship tax credit, Lifetime Learning tax credit and the Tuition and Fees deduction — are at risk of being eliminated. Even the Pell Grant program may suffer further cuts as Congress tweaks the program’s eligibility criteria.

Even if there are no further cuts to student financial aid, government grants are unlikely to keep pace with increases in college costs. College is going to become much less affordable as a result, forcing students to graduate with thousands of dollars of additional debt.

It may not be called a tax increase, but cutting student aid is effectively taxing students.

Practical Tips for Families

So what can students and their families do to deal with these changes?

First, they should try to reduce their reliance on debt to pay for college. Every dollar you borrow will cost you about two dollars by the time you pay back the debt, so it is literally cheaper to save than to borrow.

  • Every dollar saved is about a dollar less you will need to borrow. 529 college savings plans remain one of the most tax-advantaged ways of saving for college. Families should continue saving for college every month even if the stock market continues to drop. It may be more frightening to save as the stock market drops, but dollar-cost averaging has the same impact when stock prices are decreasing as when stock prices are increasing after a recovery. Just make sure that you are in the right asset allocation, so that less of your money is in risky investments like stocks as college approaches.

  • Search for scholarships on free web sites like Every dollar you win in scholarships is about a dollar less you’ll need to borrow.

  • File the Free Application for Federal Student Aid (FAFSA). The FAFSA is your gateway to money from the federal government, state government and most colleges. Exhaust the gift aid (free money that does not need to be repaid) before relying on student loans.

  • Families should increasingly focus on the real bottom-line cost of college (e.g., the discounted sticker price after one subtracts grants and scholarships from the cost of attendance), the amount of debt and the return on investment. Enrolling at a lower-cost college, such as an in-state public college, is one of the most effective ways of cutting college costs. Living at home and buying used textbooks can also save money.

A good rule of thumb is to ensure that your debt at graduation is less than your expected starting salary, and ideally a lot less. If you borrow more than your expected starting salary, you will have difficulty repaying your student loans. You may have to use alternate repayment plans, like income-based repayment and extended repayment, which stretch out the repayment term and increase the total interest paid over the life of the loan.

Second, families can reduce the cost of debt through smarter borrowing.

  • Borrow federal first. Federal student loans are cheaper, more available and have better repayment terms than private student loans. The interest rates on federal education loans are fixed, and so won’t increase when prevailing interest rates begin rising.

  • Pay the interest on unsubsidized loans while you are in school. If you don’t pay the interest as it accrues, it will be capitalized. This means the interest will be added to the loan balance and you will end up paying interest on interest. Interest capitalization increases the loan balance on unsubsidized loans by about one-sixth on average by the time the borrower enters repayment. That doesn’t include the extra interest that will be charged over the life of the loan, which can increase total payments by as much as a third or more. Paying the interest while you are in school can save you thousands of dollars.

Third, families can write to their federal and state legislators to express concern about the current and future cuts to student financial aid and increases in college costs. The only way to prevent further cuts is to tell your representatives that this issue matters to you. That means writing to them now and voting in each election.

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