Story at a glance
- The Treasury Department announced on Wednesday a new, higher 4.99 percent interest rate for undergraduate subsidized and unsubsidized loans.
- Some federal student loans begin accruing interest as soon as the loan is disbursed, compounding for the entire life of the loan.
- Lawmakers and advocates have argued federal student loans should be interest-free.
Student loan interest rates will spike this year to levels not seen since before the pandemic after the Treasury Department announced a new set of rates Wednesday for incoming students planning to take out loans for the upcoming school year.
The new 4.99 percent rate is a sizable jump from last year’s 3.73 percent rate for undergraduate direct subsidized and unsubsidized loans. The department reassess interest rates every year, with student loans part of the 10-year note auction.
The decision comes as the nation grapples with an ongoing student debt crisis and adds to the debate over whether to eliminate interest-based student loans.
Interest rates compound student debt
Interest is at the heart of the national student debt crisis and advocates and lawmakers alike have pushed to eliminate it completely as it adds to the volume of student debt held nationally.
Some federal student loans, such as graduate loans and parent PLUS loans, begin accruing interest as soon as a loan is disbursed and can continue accruing during a period of deferment. Regardless of whether a borrower is making monthly payments or not, the interest continues to compound.
Many borrowers end up with astonishingly high interest balances that are not far from their loan’s principal balance, making it all the more challenging to pay off. That’s a process known as amortization, when loan payments are stretched over a certain period of time and result in monthly payments only covering current interest balances.
The principal balances remain untouched, and even more interest continues to accrue.
That process has allowed student debt to balloon, Kevin Miller, associate director of the Bipartisan Policy Center, told Changing America.
“Especially with people who’ve had debt for 10 or 20 years, a lot of them have stories about how they owe more than they originally did, despite having already paid off as much as their original loan,” Miller said.
That doesn’t make sense to Miller, who also noted that federal student loans are meant to be an investment in the workforce, and borrowers shouldn’t be trapped in a system that results in owing so much more than what was originally borrowed.
Among adults with student loan debt, 93 percent report borrowing to pay for their own education, while 81 percent report borrowing to pay for a child or grandchild’s education, according to the Education Data Initiative.
Eliminating interest rates on federal student loans
One proposed solution to the ongoing student debt problem is to eliminate interest on federal student loans altogether.
Sen. Marco Rubio (R-Fla.) has been pushing for that reform since 2019, before reintroducing his “LOAN Act” legislation in August last year. The bill suggests instating a one-time financing fee instead of charging interest, which would be paid over the life of the loan and not accumulate with age.
That financing fee would be fixed, meaning it would not increase over time, and all borrowers would automatically be placed in an income-based repayment (IBR) plan. Borrowers would only pay 10 percent of their earnings in excess of 150 percent of the federal poverty line. Any borrower earning less than 150 percent of the federal poverty line would not have to pay any monthly payments on their loan.
“Working-class Americans should be able to pursue an education without having to worry about finding themselves trapped in an insurmountable debt cycle for years beyond graduation,” Rubio said in a statement.
An imperfect solution
Sandy Baum, a senior fellow for the Center on Education Data and Policy at the Urban Institute, told Changing America an upfront payment may not make sense for all borrowers.
For example, some borrowers may be able to pay their loans back quickly but would still be charged the same upfront fee as someone who takes 10 to 20 years to pay off theirs—while inching them closer to total loan forgiveness under certain conditions set by the federal government.
Eliminating interest also stands to impact borrowers differently based on how much money they are able to borrow.
“But the problem with that is that graduate students can borrow basically an infinite amount of money. So, if you borrow $5,000, the interest rate is not going to be a dramatic amount of money. But if you borrow $200,000, the idea that $20,000 go to medical school interest free, that’s a huge gift,” Baum said.
Instead of eliminating interest outright, Baum believes the federal government should consider not charging interest on the first $10,000 a borrower needs. That would help those who only borrowed a small amount of money while still charging interest to high-income earners like medical and law students.
In an analysis for Urban Institute, Baum and Donald Marron point out that the federal government borrows money when it issues student loans, because they’re treated as valuable financial assets who are expected to return interest along with principal payments.
For those who already have existing loans with the federal government, the new Treasury Department rate hike won’t affect them, but it will cost more for students planning to take out loans this summer for the 2022-23 school year and throughout the life of those loans.
Private loans are likely to go up as well, as they typically have higher interest rates than the federal government. In 2019, the average rate for a cosigned private loan was 10.2 percent, while the federal government’s fixed interest rate was 4.53 percent for direct subsidized loans for undergraduates that same year. Approximately 16 percent of 2019 student loans were privately held.
Though President Biden has indicated he’s open to canceling up to $10,000 in federal student loan debt per borrower, it’s not clear if any reforms to how interest rates are applied to federal student loans are under consideration.
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