Reduce or Eliminate Subsidized Loans for Undergraduate Students

The Federal Direct Student Loan Program lends money directly to students and their parents to help finance postsecondary education. Two types of loans are offered to undergraduates: subsidized loans, which are available only to undergraduates who demonstrate financial need, and unsubsidized loans, which are available to undergraduates regardless of need (and to graduate students as well).

For undergraduates, the interest rates on the two types of loans are the same, but the periods during which interest accrues are different. Subsidized loans do not accrue interest while students are enrolled at least half time, for six months after they leave school or drop below half-time status, and during certain other periods when they may defer making repayments. Unsubsidized loans accrue interest from the date of disbursement. The program’s rules cap the amount—per year, and also for a lifetime—that students may borrow through subsidized and unsubsidized loans. By the Congressional Budget Office’s estimates, subsidized and unsubsidized loans will each constitute about half of the dollar volume of federal loans to undergraduate students for the 2016–2017 academic year.

This option includes two possible changes to subsidized loans. In the first alternative, only students who were eligible for Pell grants would have access to subsidized loans. The Federal Pell Grant Program provides grants to help finance postsecondary undergraduate education; to be eligible for those grants, students and their families must demonstrate financial need. Under current law, only students with an expected family contribution (EFC)—the amount that the federal government expects a family to pay toward the student’s postsecondary education expenses—of less than about $5,200 are eligible for a Pell grant, whereas recipients of subsidized loans may have a larger EFC, as long as it is less than their estimated tuition, room, board, and other costs of attendance not covered by other aid received. This change would therefore reduce the number of students who could take out subsidized loans. Specifically, CBO projects that about 30 percent of students who would borrow through subsidized loans under current law would lose their eligibility for those loans—and would instead borrow almost as much through unsubsidized loans. In the second alternative, subsidized loans would be eliminated altogether. CBO again expects that students would borrow almost as much through unsubsidized loans as they would have borrowed through subsidized loans.

Under either alternative, borrowers who lost access to subsidized loans would pay interest on unsubsidized loans from the date of loan disbursement, which would raise their costs. If a student who would have borrowed $23,000 (the lifetime limit) through subsidized loans, beginning in the 2017–2018 academic year, instead borrowed the same amount through unsubsidized loans, that student would leave school with additional debt of about $3,400. Over a typical 10-year repayment period, the student’s monthly repayment would be $37 higher than if he or she had borrowed the same amount through subsidized loans.

When estimating the budgetary effects of proposals to change federal loan programs, CBO is required by law to use the method established in the Federal Credit Reform Act (FCRA). FCRA accounting, however, does not consider all the risks borne by the government. In particular, it does not consider market risk—the risk that taxpayers face because federal receipts from payments on student loans tend to be low when economic and financial conditions are poor and resources are therefore more valuable. Under an alternative method, the fair-value approach, estimates are based on market values—market prices when they are available, or approximations of market prices when they are not—which better account for the risk that the government takes on. As a result, the discount rates (or interest rates) used to calculate the present value of higher loan repayments under the option are higher for fair-value estimates than for FCRA estimates, and the savings from those higher repayments are correspondingly lower. (A present value is a single number that expresses a flow of current and future payments in terms of an equivalent lump sum paid today; the present value of future cash flows depends on the discount rate that is used to translate them into current dollars.)

Estimated according to the FCRA method, federal costs would be reduced by $8 billion under the first alternative and by $27 billion under the second alternative from 2017 to 2026. According to the fair-value method, over the same period, federal costs would be reduced by $7 billion under the first alternative and by $23 billion under the second.

An argument in favor of this option is that providing subsidies by not charging interest on loans for a period of time may unnecessarily and perhaps harmfully encourage borrowing; it may also make it hard for students to evaluate the cost of their education net of subsidies. Another argument in favor of the option is that some postsecondary institutions may increase tuition to benefit from some of the subsidies that the government gives students; reducing subsidies might therefore slow the growth of tuition. If institutions responded in that way, they would at least partially offset the effect of higher borrowing costs on students’ pocketbooks. Also, the prospect of higher loan repayments upon graduation might encourage students to pay closer attention to the economic value to be obtained from a degree and to complete postsecondary programs more quickly. And for most college students, $37 a month in additional costs is small compared with the benefits that they obtain from a college degree.

An argument against this option is that students faced with a higher cost of borrowing might decide not to attend college, to leave college before completing a degree, or to apply to schools with lower tuition but educational opportunities not as well aligned with their interests and skills. Those decisions eventually could lead to lower earnings. Moreover, for any given amount borrowed, higher interest costs would require borrowers to devote more of their future income to interest repayments. That, in turn, could constrain their career choices or limit their ability to make other financial commitments, such as buying a home.