What Elizabeth Warren Gets Wrong (and Right) About Student Loans

Elizabeth Warren wants a huge student loan interest rate cut. Here's why that doesn't make sense.

In this March 7, 2013 file photo, Sen. Elizabeth Warren, D-Mass., pauses while questioning a witness at Senate Banking Committee hearing on anti-money laundering on Capitol Hill in Washington.
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Sen. Elizabeth Warren, D-Mass., introduced her first piece of legislation this week — a bill intended to bring interest rates on student loans way, way down. That could be a boon to students nationwide, but it also might not be the best idea.

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Warren's plan is to make student loan interest rates the same as the Federal Reserve discount rate, currently at 0.75 percent. That is the rate at which banks can borrow money from the government for short-term liquidity purposes. Student loan interest rates are currently set to double to 6.8 percent in July.

The senator best known for launching the Consumer Financial Protection Bureau and cracking down on banks used Wall Street as a foil for student borrowers in introducing the bill.

"[T]he federal government is going to charge students interest rates that are nine times higher than the rates for the biggest banks - the same banks that destroyed millions of jobs and nearly broke this economy," she said in a statement.

 

Warren proposes to implement the super-low rate for only one year, in order to give Congress time to create a longer-term fix for student loans. Still, it's important to note that there is good reason why interest rates for students are higher than the discount rate for banks. One is that the discount window funds short-term borrowing, often for overnight loans. Student loans, as any debtor knows, last much longer than one night. And even the U.S. government faces far higher interest rates than 0.75 percent on its long-term borrowing.

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"The flaw in Senator Warren's logic is that these are long-term loans that are being presumably funded with longer-term borrowing by the Treasury," says James Angel, associate professor of finance at Georgetown University's McDonough School of Business. "So even though the t-bill rate right now is effectively zero, for longer-term debt the government is effectively paying several percentage points more."

Even the U.S. government, the epitome of a trustworthy borrower, is paying around 1.8 percent in interest on its 10-year loans now, and nearly 3 percent on its 30-year loans. Meanwhile, the Department of Education reported late last year that federal student loan default rates for borrowers in their first two years of repayment were at 9.1 percent in fiscal year 2011, up from 8.8 percent the year before. And though student borrowers have to pay eventually, as it's difficult to discharge student debts via bankruptcy, they still are paying later and later. Delinquencies are also rising sharply, as the Federal Reserve Bank of New York reported in February:

(New York FedFRBNY Consumer Credit Panel/Equifax)

In an open market, shakier borrowers get higher interest rates. Therefore, one could argue that it wouldn't make sense for student borrowers to get better terms than the government. A spokesperson from Warren’s office, however, says that lower interest rates will mean lower default rates for students, just as low interest rates mean reduced risk of default for U.S. banks. The question is whether a 6.8 percent interest rate would be justified while interest rates on so many other assets – mortgages, treasury bonds –are near historic lows.

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Warren's bill does address this very problematic point by taking student loan interest rates out of Congress' control. With Congress dictating the rates students pay,student loan interest can be out of step with broader financial markets.

Warren's office has not responded to a request for comment on her proposal.

She's not the first to propose this type of change. In its most recent budget, the Obama Administration proposed setting interest rates on subsidized student loans at 0.93 percentage points above the 10-year treasury bond rate. For unsubsidized loans, it would be 2 percentage points above that. At the current 10-year yield of 1.8 percent, that would put interest rates at around 2.7 and 4.7 percent, respectively. Senate Republicans also introduced a bill last month that would set rates on all new loans to 3 percentage points above the 10-year Treasury—or at around 4.8 percent.


Corrected on : Updated on May 9, 2013: This article was updated to include comments from Sen. Warren’s office.