Student Loan Interest Rate Policy

"Student Loan Interest Rate Policy" follows  last week's blog on "Headaches of the English Student Loan Program" and further examines the challenges of getting university financing policy right.

One student aid policy debate that pops up periodically around the world – most recently in the United Kingdom - is the question of student loan interest rates.  On the one hand, you have people who use a slightly medieval line of thought to claim that any interest on loans is a form of “profit” and that governments should be forbidden from charging it.  On the other side, you have people who note that loan interest subsidies by definition only help those who have already made it to higher education and could probably be repurposed to grants and other aid that would help people currently shut out of higher education.

So, what’s the right student loan interest policy?  Well, there are four basic policy options:

Zero nominal interest rates.    Under this policy there is simply no interest at all charged on the loans.  But because inflation erodes the value of money over time, this policy amounts to paying students to borrow since the dollars with which students repay their loans are worth less than the ones which they borrowed several years earlier.  The cost of this subsidy can be very high, especially in high-inflation environments, Germany and New Zealand (check) are the main countries which use this option.

Zero real interest rates.  Here the value of the loans increases each year by an amount equivalent to the Consumer Price Index (CPI), but no “real” interest is charged.  Students are not being paid to borrow in the way they are in option 1, but there remains a significant government subsidy, because the government’s cost of funds (i.e. the price at which the government can borrow money) is almost always higher than inflation.  Australia is perhaps the most prominent country using this policy. 

Interest rates equal to the Government Rate of Borrowing.  In this option, interest on outstanding loans rises by a rate equal to the rate at which the central Government is able to raise funds on the open market through the sale of short-term treasury bills.  In this option, government is no longer really subsidizing loans, but students are still getting a relatively good deal because the rate of interest on the loans is substantially lower than any commercial loans.  The Dutch student aid program uses this policy, as (until quite recently) did the UK. 

Interest rates mirror rates of interest on unsecured commercial loans.  In this option, the value of outstanding loans increases by a rate similar to those available to good bank customers seeking an unsecured loan.  This can be somewhat difficult to measure definitively as different banks may have different lending policies, so a proxy linked to the prime lending rate may be used instead (e.g. prime plus 2.5%, which is the default rate in the Canada Student Loans Program).   Under this system, students are not receiving any subsidy at all vis-à-vis commercial rates, though the loan program still provides them benefit in that without a government-sponsored program they would likely be unable to obtain any loans at all. 

A loan repaid in full under this final option does indeed create a net return for government, but this does not imply a profit for government.  Loan programs the world over suffer huge losses from defaults, and without exception programs which charge these higher rates use the surplus to offset these defaults.  In this sense, this option provides from cross-subsidizing across the student body, with successful beneficiaries subsidizing those students unable to repay their loans. 

Though these are the core four options for loans, there are some twists that can be added.  One twist is to use these four policies not as absolutes, but as figures to which actual policy can be pegged.  Malaysia, for instance, has in the past a policy of charging interest equal to “inflation minus one percent”; Sweden has a policy of “government rate of borrowing plus one percent”, etc.  Thus, the actual rates are linked to one of each of the four options without following it exactly. 

Another twist is to apply different policies depending on whether the borrower is in school or in repayment.     For instance, the US and Canada charge nominal zero rates while students are in school, and higher rates afterwards (in the US, the rate differs among loan program but is pegged to the government rate of borrowing; in Canada it is linked to the Prime rate).  A third twist is to have different types of loans for different types of students.  Japan provides zero nominal interest loans to students with very good secondary school results and loans at prime to students with weaker results.  In the same vein, the US offers more expensive (“unsubsidized”) loans to wealthier students while providing subsidized ones to students from less affluent backgrounds.

A low-inflation world means loan subsidies are a lot cheaper to implement than they were, say, twenty years ago, but they are not costless.  And it’s very hard to argue that interest rate subsidies actually increase access.  There have been some substantial policy changes in loan rates across countries over the last couple of decades and no one has credibly come forward with evidence to suggest that these rates make any difference to application or enrolment rates. 

For the most part, the economic effects of loan subsidies consist of increasing the purchasing power of educated mid-to-late 20-somethings.  If you think this is a group worth subsidising, then you should be in favour of student loan subsidies.  If not, you probably should want student loan subsidies to be kept to a minimum, and the money used for things which are actually proven to increase access (such as income-targeted grants).

That said, there’s policy and there's politics.  At the moment, the pendulum in most of the world is to reduce interest on student loans – and certainly to avoid anything that looks like a market rate.  Fair enough: but that’s no reason to go overboard.  A Dutch solution – providing loans to students at government rate of borrowing for the life of the loan – is a good middle-ground solution.  Governments do not subsidize these loans, but students get a far-better-than market rate nonetheless.  A reasonable compromise all around.