Could 0% interest rates settle the student loan debate?

BY Jason ArmestoNovember 24, 2021, 3:09 PM
Students on the UCSB campus in Santa Barbara as some students face a statewide student housing crisis, as seen in November, 2021. (Al Seib—Los Angeles Times/Getty Images)

The student loan debt has become a topic of conversation nationwide, and for good reason: Since 2003, total student loan debt has grown more than 600% to $1.7 trillion. The weight of that debt has fallen on the shoulders of most college-educated American adults, with 65% of them still paying off student loans. 

Many people argue the solution is for the federal government to cancel debt outright. President Joe Biden has listened, at least to an extent—his administration has forgiven more than $11 billion in student loans since taking office. 

Still, some critics say he has not gone far enough, while others think canceling debt is unfair to those who never attended college. While the debate about student debt cancellation rages on, there’s far less discussion about cancelling interest rates for federal loans. Why not? That’s a question Ben Carlson, director of institutional asset management for Ritholtz Wealth Management, addressed in a blog post in August.

“It’s an interesting thought but I haven’t seen where that’s getting any traction,” says Barry Coleman, vice president of counseling and education programs at the National Foundation for Credit Counseling. “I haven’t seen any proposals coming out of the federal government other than just forgiveness for those that have already borrowed.”

Could addressing interest rates offer a compromise in the debate about what to do about student loan debt? Here’s what two experts told Fortune.

Why the government charges interest on student loans

The federal government doesn’t charge interest on student loans to make a massive profit. It does so to offset the costs of loaning money, including inflation, and because lending money is risky. Some people will default on their loans, and that means lost revenue for the government, so the federal government reduces its risk of losing money by charging interest. 

Whether they are making minimum wage or have inherited millions, any student who takes out a federal student loan pays the same interest rate. For undergraduates that rate is currently 3.73%, and it’s 5.28% for graduate students. The rate adjusts each spring, and is tied to the current yield on 10-year Treasury notes. This formula for setting interest rates is relatively new. 

“Congress used to set the interest rate on the loan by picking a rate that they thought seemed good that day. It literally was that ridiculous,” says Jason Delisle, a senior policy fellow at the Urban Institute. In order to change interest rates, the House, Senate, and President all had to agree on a new rate—a slow, ineffective process that meant student loan interest rates rarely changed. During the Great Recession, it became clear this strategy had problems. 

Despite interest rates dropping for other federal loan programs as a response to financial hardship, student loan interest rates stayed at 6.8%, a figure Congress had agreed upon in 2002. “It started to become clear that the rates had nothing to do with what was happening in the economy, and now rates adjust based on the year that you take a loan,” Delisle explains.

How 0% interest would benefit students 

To see just how much money a student spends on interest, let’s do some quick math. 

If you take out a 10-year loan for $50,000, your monthly payments would be about $500 at the current federal interest rate for undergraduates (3.73%) vs. $417 if you weren’t charged interest. Over the life of the loan, that’s a savings of nearly $10,000—an amount that can make a significant difference in someone’s life. 

“It would cover rent. It would make it perhaps easier for some to qualify for mortgages,” Coleman says. “If they have other debt they could perhaps retire that debt quicker just because they don’t have to worry about additional interest being added to federal student loans.”

Eliminating interest rates would also eliminate the possibility of interest capitalization, which happens when interest goes unpaid and essentially compounds upon itself. “That’s where people really begin feeling that they’re trapped and not making any progress towards paying the loans down,” Coleman says. While claiming forbearance to delay payments can be tempting for young people, Coleman and the NSCC urge borrowers to develop a plan to retire their debt as quickly as possible instead of kicking the can down the road. “That’s where we see people get into trouble,” he warns. 

How much would students really save?

The problem with the hypothetical math above is that most students aren’t taking out $50,000 in loans. For the class of 2019, the average student loan debt for undergraduates was $28,950. So for a student taking out that average amount spread over 10 years, what kind of difference would 0% interest make compared to 3.73%?

About $48 a month. 

People with a lot of debt could save a great deal of money if interest was eliminated. But the reality is that most students are not taking out loans large enough for the interest to be deeply impactful. 

“I would be surprised if a 3% interest rate on a student loan would make or break someone’s decision to go to college,” Delisle says. 

But what about grad students? They pay higher interest rates than undergraduates do, so setting their rate to 0% would result in them saving more money. But interest rates for graduate school are higher because these borrowers can largely afford it. Generally speaking, the more advanced the degree that people have, the more money they have—along with earning potential. 

The cost of 0% interest

While 0% interest could give students some financial relief, Coleman notes that someone would have to pick up the tab for the government’s lost revenue. “If it was just zero then I think it would fall on the backs of taxpayers because the program is not paying for itself.” 

Delisle agrees. “Taxes would have to go up or the government would have to cut spending on something else,” he says. And to take it a step further, he notes that student interest rates are pretty low already. At 3.73% currently, the rate is comparable to a mortgage, though student loans are far easier to acquire. “There is no credit check, there is no collateral requirement, there is no down payment. So in that regard it’s rather remarkable it’s about the same rate as a mortgage,” he says. 

Meanwhile, borrowing money for free is practically unprecedented. “Everybody would take out loans because it’d be the best deal around. It’d be the only place you could get a 0% interest loan,” Delisle says. There would likely be an explosion in borrowing, but not necessarily because more people would go to college. Instead people would take advantage of a rare opportunity. 

“That’s what a financial advisor would tell them to do,” Delisle claims. “They’d say, ‘Look, just keep your savings in a savings account and let’s take out the 0% interest loan.’” Even if someone had enough money in the bank to pay for college, they’d be incentivized to take the loan instead.

All of that interest-free borrowing would result in lost revenue for the government—lost revenue that policymakers have to find another way to collect. It’s quite possible that taxes would go up, resulting in higher taxes for the very students who a 0% interest rate was intended to help. 

So while eliminating interest rates may sound good in theory, in practice it could be more trouble than it’s worth. As long as students don’t get far behind on their loans, the interest rate can be negligible. “So make it a priority, develop a plan, pay as much as you can toward those student loans and get rid of them,” says Coleman. “That way you can focus on saving for other things like buying a home and having a family.”

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