CONGRESS OF THE UNITED STATES

CONGRESSIONAL BUDGET OFFICE

A

PAPER

MAY 2006

The Cost of the 

Consolidation

 Option for 

Student Loans

CBO
Pub. No. 2691
The Congress of the United States O Congressional Budget Office

CBO

The Cost of the 

Consolidation Option for Student Loans

May 2006

A

PAPER

Preface

Federal student loans provide borrowers with options to modify the terms of those loans 

after origination. One option allows borrowers to consolidate their loans, combining individual loans into a single obligation and converting from a variable interest rate to a fixed rate 

that is based on a short-term interest rate. Under that consolidation option, borrowers also 

have more flexibility to extend the term to maturity of their loans. 

The option to convert a variable-rate loan into a fixed-rate loan at the prevailing variable rate 

conveys a substantial benefit to borrowers and imposes a corresponding cost on the government and taxpayers, which is difficult to assess using conventional budgeting techniques. This 

paper—prepared in response to a request from the Honorable Jim Nussle, Chairman of the 

House Budget Committee, and the Honorable John Boehner, former Chairman of the House 

Education and the Workforce Committee—uses options-pricing methods to estimate the cost 

of the consolidation option. In keeping with CBO’s mandate to provide objective, impartial 

analysis, the report makes no recommendations.

Steven Weinberg and Damien Moore prepared the paper under the supervision of Robert 

Dennis and Marvin Phaup. Nabeel Alsalam, Chad Chirico, Paul Cullinan, Deborah Kalcevic, 

Angelo Mascaro, Bill Randolph, and Judy Ruud of CBO offered many helpful comments. 

Deborah Lucas of Northwestern University and the National Bureau of Economic Research 

reviewed several drafts of the paper and provided valuable suggestions. Will Melick of Kenyon 

College also provided beneficial comments. (The assistance of external reviewers implies no 

responsibility for the final product, which rests solely with CBO.) 

Christine Bogusz edited the paper, and John Skeen proofread it. Maureen Costantino prepared the report for publication and designed the cover, and Lenny Skutnik printed copies of 

the paper.

Donald B. Marron

Acting Director

May 2006

Contents

Summary vii

The Option to Consolidate 2

Extension of the Loan’s Term to Maturity 2

Special Allowance Payments to Lenders 2

Benefits to Borrowers 2

Factors Affecting Costs to the Government 3

The Budgetary Costs of Consolidation 4

The Government’s Costs of Consolidation 4

Costs of Consolidation Estimated Using Historic Interest Rates 5

Costs of Consolidation Estimated Using Projected Interest Rates 5

The Costs of Consolidation Under Alternative Policies 6

Consolidation at a Fixed Long-Term Interest Rate 6

Consolidation at a Variable Interest Rate 6

Consolidation at a Fixed Short-Term Interest Rate 6

Consolidation at a Fixed or Variable Interest Rate 7

Appendix A: Assumptions Underlying the Cost Estimates in 

This Analysis 9

Appendix B: The Economics of the Consolidation Option 11

Table

1. Average Costs of Consolidation for Variable-Rate Loans 5

Figure

B-1. The Market Value of a $100 Loan 11

Summary

The federal government’s student loan programs for 

higher education convey substantial financial benefits to 

borrowers because of their broad availability and favorable terms. They offer:

B Interest rates that are independent of a borrower’s 

credit status and typically several percentage points 

below those on purely private loans; 

B Deferred repayment of the debt while the borrower is 

in school; and

B An option to convert from a variable interest rate to a 

fixed interest rate, usually on more favorable terms 

and with a longer period until maturity. 

Of the various provisions included in a federal student 

loan contract, the option to consolidate individual loans 

contributes greatly to a borrower’s benefits and the cost of 

the program to the government and taxpayers. Most of 

the benefit comes from the fact that consolidation allows 

a borrower to convert loans with variable interest rates 

(which will not be issued after June 30, 2006) into one 

loan with a long-term fixed rate at the currently prevailing variable rate, which is linked to short-term market 

rates. Borrowers can choose when to consolidate, and 

they tend to do so when market conditions allow them to 

lock in long-term loans at the lowest interest rates. 

The magnitude of the benefits from consolidation varies 

significantly across time and among borrowers. Generally, 

benefits are realized disproportionately by borrowers who 

consolidate during periods when short-term interest rates 

are low and long-term interest rates are higher. For example, the benefit to borrowers averaged $26 per $100 in 

principal for loans consolidated in the 2004 program 

year, whereas for loans consolidated in 2000, the average 

benefit was only $2 per $100 in principal.1

 Benefits are 

also relatively greater for borrowers with the largest loan 

balances (usually borrowers with professional degrees), 

because the maximum extension of the loan’s term to 

maturity increases with the size of the loan. Benefits are 

also relatively high for borrowers with poor credit ratings, 

who might not be able to obtain a loan in the private 

market or who would pay higher interest and fees for a 

loan without a federal guarantee. 

The government’s costs increase when borrowers consolidate their loans because the resulting fixed-interest-rate 

loan is usually more deeply subsidized than the original 

variable-rate loans it replaces. The Congressional Budget 

Office (CBO) estimates that the present value of the cost 

of the consolidation option has averaged $4.60 per $100 

of loans originated.2 That is, the option to consolidate 

has cost the government (and benefited borrowers) about 

the same amount as forgiving the repayment of nearly 5 

percent of borrowers’ loan principal. Today’s relatively 

small difference between long- and short-term interest 

rates implies that if the rules in effect before July 2006 

continued, the prospective cost of the consolidation option would be lower than that historic average. In CBO’s 

estimation, the average cost of the option for the 2006-

1. Those estimates are for the value of loans consolidated in 2004 and 

2000, not the value of the option for loans originated in those 

years. The latter is the estimate recognized for Congressional 

scorekeeping purposes according to provisions of the Federal 

Credit Reform Act. 

2. That estimate is based on the behavior of interest rates over the 

past 20 years and the terms of consolidation in effect since 1998. 

The cost of the option to consolidate is the difference in the 

present value of the government’s cash flows with and without the 

option to consolidate. Consolidation is not the only means available to borrowers to extend the term of their loans, and many borrowers would extend the term even if consolidation was not 

available. Thus, the cost of consolidation excludes the cost of any 

term extension that would have occurred without the consolidation option.
VIII THE COST OF THE CONSOLIDATION OPTION FOR STUDENT LOANS

2015 period would be about $1.50 per $100 of the principal amount. 

The changes scheduled to take effect in July 2006 fundamentally change the terms of the student loan program, 

fixing the interest rate on original and consolidated loans 

at 6.8 percent and 6.875 percent, respectively. Those 

changes eliminate the possibility of consolidating at a rate 

below 6.875 percent. Under the rules in effect after July 

2006, the average cost of consolidation for the 2006-

2015 period will be about 40 cents per $100 of loans 

originated, CBO estimates. One important reason for 

the sharp reduction in cost is that consolidation provides 

few benefits to borrowers eligible to increase their loan 

maturity through the extension provision of their existing 

loans.3

Other implications of this analysis include the following:

B Changing loan terms to reduce (or increase) the cost 

of a single feature of a program may have the opposite 

effect on the program’s total costs. For example, the 

change from a variable interest rate to a fixed rate reduces the cost of consolidation, but it may increase the 

overall cost of the student loan program. 

B Changing the interest rate on consolidated loans to 

one that matched the market rate on loans with the 

same term to maturity would reduce both the cost of 

consolidation and the program’s total costs.

B Ending both the option to consolidate and the right to 

extend terms under other provisions of a loan would 

reduce costs more than ending only the consolidation 

option.

Lawmakers have frequently adjusted the terms of the student loan program. The analysis in this paper illustrates 

the financial costs to the government that would result 

from policy alternatives that have existed or been considered in the past. It also applies to options that might 

be considered by the Congress for use in other credit 

programs.

3. That estimate assumes that borrowers who consolidated their 

loans were not eligible to extend the loans’ term to maturity under 

any other provisions. 
The Cost of the 

Consolidation Option for Student Loans

Almost all new government loans to assist students in paying for higher education are Stafford loans, 

either made directly by the government under the Federal 

Direct Student Loan (FDSL) Program or made by private 

lenders and guaranteed by the Department of Education 

under the Federal Family Education Loan (FFEL) Program.1 Under terms in effect through June 2006, Stafford 

loans carry a variable interest rate that is adjusted annually at the beginning of July. That variable rate is the interest rate on the three-month Treasury bill (based on 

the last Treasury auction in May) plus a markup. The 

markup is 1.7 percentage points while the borrower is in 

school, in a six-month grace period after leaving school, 

and in periods of deferment and 2.3 percentage points for 

the remaining life of the loan. The interest rate borrowers 

pay is capped at 8.25 percent. Borrowers typically decide 

whether to consolidate their loans soon after they have 

finished their education. By consolidating, borrowers 

combine their variable-rate loans taken out in different 

years into a fixed-rate loan at the current variable rate. 

Private lenders offer terms that are substantially less favorable than those on Stafford loans. In the private market, 

lenders typically charge a variable interest rate that is 2 to 

3 percentage points higher than that on Stafford loans, 

and the interest rate is not capped. In addition, private 

lenders have more restrictive policies on loan deferments 

and forbearance. 

For Stafford loans, borrowers pay less than the government’s cost of their loans. In general, the subsidy stems 

from the fact that the interest rate and fees charged by the 

government are insufficient to cover the costs of late payments, defaults, market risk, loan servicing, and the collection of bad debts.2

Like Stafford loans, Parent Loans for Undergraduate 

Students (PLUS) are offered by guaranteed lenders as well 

as directly by the federal government. Such loans (under 

terms prevailing through June 2006) are variable-rate 

loans with the borrower’s interest rate set at the threemonth Treasury bill rate plus a markup of 3.1 percentage 

points. The variable rate is capped at 9 percent. PLUS 

borrowers also have an option to consolidate their loans. 

Although the estimates in this paper are restricted to the 

consolidation option in the Stafford program, the analysis 

also applies to the PLUS program. 

The division of activities between the government and 

guaranteed lenders differs substantially for the direct 

and guaranteed loan programs. Under the direct-lending 

program, the government disburses loan principal and 

receives repayments from borrowers. The government 

also incurs all administrative costs, including those for 

servicing and collection, and receives cash from recoveries 

on defaulted loans. Under the FFEL guaranteed program, 

lenders are responsible for financing, originating, and 

servicing the loans. The government makes periodic 

special-allowance payments (SAPs) to lenders to supplement payments received from borrowers, and it assumes 

almost the entire cost of guaranteed loans that default. 

1. See Congressional Budget Office, Private and Public Contributions 

to Financing College Education (January 2004). For a more 

detailed description of the student loan programs, see Congressional Budget Office, Subsidy Estimates for Guaranteed and Direct 

Student Loans (November 2005).

2. A subsidy is also given for so-called unsubsidized Stafford loans. 

Unsubsidized in that case means only that the borrower is responsible for repaying the interest that accrues on the loans while he or 

she is in school. But the interest rate itself is a below-market, subsidized rate. 
2 THE COST OF THE CONSOLIDATION OPTION FOR STUDENT LOANS

The Option to Consolidate

Borrowers in the direct and guaranteed student loan programs may consolidate one or more loans into a single 

loan, extend that loan’s term to maturity, and fix the interest rate at the weighted average of the current shortterm (variable) rates on those loans. At consolidation, 

three changes occur that significantly affect the flow of 

payments among borrowers, lenders of guaranteed loans, 

and the federal government: 

B The interest rate to borrowers no longer varies; 

B The term to maturity of the loans is extended;3 and

B For the guaranteed program, private lenders receive a 

reduced net payment from the government. However, 

in present-value terms, the savings to the government 

from that lower subsidy rate are partly offset, and in 

some cases more than fully offset, by the longer duration of the consolidated loan. 

Extension of the Loan’s Term to Maturity 

The consolidation option is not the only means by which 

borrowers can extend the term to maturity of their loans. 

Since 1998, borrowers have had the option to extend the 

term beyond the standard 10 years without consolidating. 

For direct loans, borrowers can extend the term to about 

the same maturity (depending on the size of their loans) 

as they can by consolidating and still retain the right to 

consolidate later. For guaranteed loans, the option to extend without consolidating is more restricted: extension 

for 25 years is available only on loans with a balance of 

$30,000 or more from a single lender.4 Although some 

borrowers extend their loan’s term to maturity without 

consolidating, most extensions occur with consolidation 

because of the more-favorable loan terms. 

Thus, not all of the costs of extending a loan’s term to 

maturity are appropriately considered to be costs of consolidation. Estimates of the government’s costs for the 

consolidation option in this analysis exclude the costs of 

extension that would have occurred if the consolidation 

option was not offered. 

Special Allowance Payments to Lenders

For unconsolidated guaranteed loans, lenders receive the 

higher of:

B The interest rate the borrower pays on the loan 

(2.3 percentage points above the rate on the 90-day 

Treasury bill) and 

B 2.34 percentage points above the rate on 90-day commercial paper (CP), or promissory notes usually issued 

by corporations.5

If the rate paid by borrowers is less than the CP-based 

rate, the government makes a special allowance payment 

to lenders for the difference. For consolidated loans, lenders continue to receive the higher of the borrower’s rate 

(now a fixed rate) and the CP-based rate.6

After consolidation, the CP-based interest rate paid to 

lenders is increased to 2.64 percentage points above the 

rate on 90-day CP. However, for a consolidated loan, 

lenders also pay a 1.05 percent annual consolidation fee 

to the federal government. The net effect is to lower the 

interest rate guaranteed to lenders by approximately 0.75 

percentage points on consolidated loans. If the borrower 

extends the loan’s term to maturity but does not consolidate, the guaranteed interest rate to lenders does not 

change; it is same as for the original loan. 

Benefits to Borrowers

The consolidation option provides borrowers with two 

distinct financial benefits. First, by allowing borrowers to 

refinance to a long-term fixed-rate loan at the interest rate 

that applies to a variable-rate loan, the government has effectively extended them long-term credit at a short-term 

3. The amount by which borrowers can extend the term to maturity 

of their loans when consolidating is based on the outstanding balance: for a balance of at least $7,500, the term may be extended to 

12 years; for at least $10,000, 15 years; for at least $20,000, 20 

years; for at least $40,000, 25 years; and for at least $60,000, 30 

years. 

4. The Deficit Reduction Act of 2005 restricts the option for an 

extension under the direct loan program to the same terms available under the guaranteed loan program: up to 25 years for loans 

with a balance of $30,000 or more.

5. For borrowers who are in school and during the grace period afterward, the lender’s guaranteed interest rate is the CP rate plus 1.74 

percentage points. One possible rationale for the link between the 

SAP and the commercial paper rate is that the CP rate may 

approximate the cost of funds to the lender, and the spread over 

the CP rate may approximate the costs to service the loan.

6. Under the Deficit Reduction Act of 2005, if the rate paid by 

borrowers exceeds that CP-based rate, lenders retain only the 

CP-indexed rate and pay the difference to the government.
THE COST OF THE CONSOLIDATION OPTION FOR STUDENT LOANS 3

rate. (That provision disappears when the program’s rules 

change in July 2006.) The consolidation option is especially valuable when short-term interest rates are low relative to long-term rates because the low short-term rate 

can be locked in for the life of the loan. Conversely, if 

short-term rates are higher than long-term rates, borrowers can defer consolidation. Under rules in effect through 

June 2006, a borrower can know the subsequent year’s 

consolidation interest rate before deciding whether to 

consolidate at the current year’s rate, further increasing 

the value of the option.

Second, because student loans carry a below-market interest rate, extending the term to maturity of a loan 

lengthens the period over which the borrower receives 

a subsidy, thus increasing its value.7 Extending the term 

of a loan also lowers the borrower’s monthly payment. 

(Some borrowers might prefer the lower monthly payment, even at a higher interest rate.) Finally, a single payment is likely to be more convenient for borrowers with 

multiple loans. 

Factors Affecting Costs to the Government 

The benefits to borrowers who consolidate their loans 

impose corresponding costs on the government. The 

costs depend on the initial level and volatility of interest 

rates over the life of the consolidated loan, differences 

between the interest rates the government charges and 

the rates charged by private lenders, and the behavior of 

borrowers.

Term Structure of Interest Rates. The costs of consolidation depend on the term structure of interest rates—the 

relationship between interest rates and a loan’s term to 

maturity. Consolidation is more costly to the government 

the further short-term rates are below long-term rates. 

That is, the greater the gap, the further the new locked-in 

rate will be below the market rate for a loan of comparable maturity. (See Appendix B for more details.)

Interest Rate Volatility. Bigger period-to-period changes 

in market interest rates increase the frequency of large 

gaps between long-term and short-term rates. Thus, the 

more volatile interest rates are, the higher the government’s expected costs of consolidation will be. 

Interest Rate Cap. Under current law, the interest rate on 

Stafford loans is capped at 8.25 percent. Consequently, 

the total cost to the government of unconsolidated 

Stafford loans is higher when market interest rates are 

high (above 8.25 percent, for example) than when interest rates are well below the cap. Although a reduction in 

the cap (to 5 percent, for example) would reduce the 

value of the consolidation option, the overall cost of the 

program would be far higher. In other words, lowering 

the cap would reduce the potential gain from consolidation because the borrower’s rate on unconsolidated loans 

could not exceed 5 percent. At the same time, a rate with 

such a low ceiling would increase the interest subsidy to 

the borrower. 

Different Interest Rates Charged by the Government and 

Private Lenders. When the government lends money at a 

below-market rate or pays lenders of guaranteed loans to 

make loans at below-market rates, it confers a subsidy on 

the borrower at the expense of taxpayers, who ultimately 

bear the cost of the benefit. The greater the difference 

between the legislated government rate and the market 

interest rate, the higher the cost of consolidation will be. 

Borrowers’ Behavior. The government’s costs of consolidation depend on whether and when borrowers choose to 

exercise that option. Many factors influence those decisions, including interest rate conditions and borrowers’ 

total amount of outstanding loans and access to other 

sources of credit. Other individual factors that may influence the decision to consolidate include a borrower’s financial sophistication, the desire to reduce the number of 

separate monthly bills, and the willingness to invest the 

time and effort to complete the necessary paperwork. If 

borrowers choose not to consolidate their loans, then the 

government’s costs will diminish.

Two features of the student loan program favor consolidation early in the life of a loan. First, loans consolidated 

while borrowers are in school, in the military or other 

designated service, or during the six-month period after 

leaving school bear interest rates 0.6 percentage points 

below those consolidated at a later time.8

 Second, the repayment schedule for original loans is set to amortize 

those loans over 10 years, which means that the principal 

balance declines over time. All else being equal, the benefit to borrowers from consolidation increases along with 

7. Term extension through consolidation is the only way many 

borrowers in the guaranteed loan program can extend the term of 

their loans.

8. The reduction of 0.6 percentage points will not apply to loans 

originated after June 2006.
4 THE COST OF THE CONSOLIDATION OPTION FOR STUDENT LOANS

the principal balance, implying a larger gain from early 

consolidation.

The very low level of short-term Treasury rates since 

2002 has increased consolidation rates to 80 percent of 

the estimated eligible loan volume.9 That increase may 

also reflect the stronger marketing of consolidation loans 

by Stafford lenders. Current consolidation rates are unlikely to be maintained when interest rates rise. The 

higher interest rate for the 2005-2006 program year has 

already significantly reduced the government’s cost of 

consolidation relative to that cost in the recent past, 

both because the cost per dollar of loans consolidated has 

fallen and because the consolidation rate is expected to 

decline.10

The Budgetary Costs of Consolidation

The budget accounts for student loans under rules specified in the Federal Credit Reform Act (FCRA). For most 

federal credit programs, that law requires that the budget 

recognize the long-term expected cost of a loan or loan 

guarantee—including the expected value of defaults—

when the loan is disbursed. Furthermore, the budgetary 

cost also must include—when the loan is originated—the 

expected costs of changes in loan terms from the exercise 

of any option embedded in the loan agreement. 

The budgetary costs under the FCRA do not include all 

the costs to the government of its credit programs, however. For example, by requiring the use of Treasury interest rates to calculate the present value of expected cash 

flows to and from the government, the FCRA omits the 

cost of market risk. The market value of options, such as 

the student loan consolidation option, cannot be estimated accurately using conventional budgeting methods 

without also taking into account the relationship between 

the cash flows from a credit instrument and the state of 

the economy.11 Moreover, there are some costs (such as 

administrative costs for direct loans) that the budget recognizes as they are paid, rather than as part of the expected cost of the loan or guarantee as it is made. As a 

consequence, budget calculations of costs under FCRA 

are incomplete. 

By contrast, the market cost of a loan or loan guarantee is 

a more comprehensive estimate of the value of all resources used by that activity, valued at market prices and 

using risk-adjusted discount rates. Thus, the market cost 

includes estimates of all the foreseeable costs attributable 

to the loan or guarantee as well as the fees and interest 

rates that the market would charge for similar loans. The 

estimates of the costs of consolidation in this analysis are 

for the full market cost to the government, including the 

cost of market risk.

The Government’s Costs of

Consolidation

For Stafford loans, the government’s cost of the consolidation option is the difference in the present value of the 

government’s cash flows (discounted at market rates) with 

and without the option to consolidate. 

The government’s cash flows in the direct loan program 

are the disbursement of principal and the stream of repayments over time net of administrative costs and losses due 

to default. The government’s cash flows in the guaranteed 

loan program are the special allowance payments made to 

lenders (net of fees) and outlays for defaults (net of recoveries). 

The government’s cash flows change with consolidation. 

Specifically, the change in a loan’s term to maturity affects 

a borrower’s schedule of repayments, the size and duration of the net payments by the government to lenders, 

and the period over which the government must pay administrative costs for the direct loan program. In estimating the market-based costs of consolidation, all cash flows 

in this analysis are discounted to present values using 

risk-adjusted interest rates.

9. “Estimated eligible loan volume” is defined as the average annual 

volume of originations over the previous five years. 

10. The volume of loans consolidated in the 2005-2006 program year 

has been greater than normal as borrowers consolidate their loans 

in anticipation of sharply higher short-term interest rates in the 

2006-2007 program year. Perhaps also contributing to that higher 

rate of consolidation might be misconceptions by borrowers about 

the terms of the consolidation option in future years from enactment of the Deficit Reduction Act of 2005. Those new terms will 

not affect the consolidation option for existing variable-rate loans, 

however. 

11. See Congressional Budget Office, Estimating the Value of Subsidies 

for Federal Loans and Loan Guarantees (August 2004).
THE COST OF THE CONSOLIDATION OPTION FOR STUDENT LOANS 5

Table 1.

Average Costs of Consolidation for Variable-Rate Loans

Source: Congressional Budget Office.

Costs of Consolidation Estimated Using Historic 

Interest Rates 

Under rules in effect from 1998 through June 2006 and 

under the assumption of a distribution of interest rates 

similar to that of the past 20 years, the Congressional 

Budget Office (CBO) estimates that the cost of the option to consolidate a variable-rate loan into a fixed-rate 

loan averages about $4.60 per $100 of loan principal 

originated (see Table 1).12 That estimate is a dollarvolume weighted average of the costs for both the FFEL 

and FDSL programs. Under current law, the interest rate 

is fixed at the three-month Treasury bill rate plus 2.3 percentage points.

Under the change in law scheduled to take effect in July 

2006, the interest rate to borrowers on new student loans 

will be fixed at 6.8 percent. The option to consolidate 

will continue to be available, but at an interest rate of 

6.875 percent. Moving to a fixed interest rate on the original loan eliminates borrowers’ opportunity to lock in a 

short-term rate when it is well below the long-term rate. 

As a result, under those new terms, the cost of the consolidation option (based on extending a loan’s term to maturity) will be 40 cents per $100 of principal originated, 

CBO estimates, under the assumption of interest rates 

like those that prevailed over the past 20 years. (Because 

the terms of the original loans—which are at a fixed 

rate—differ from those in effect through June 2006, that 

estimate is not included in Table 1.)13

Costs of Consolidation Estimated Using Projected 

Interest Rates

If current loan terms remained unchanged, the projected 

costs of consolidation would average $1.50 per $100 

originated, CBO estimates. Those costs were estimated 

using a distribution of interest rates consistent with 

CBO’s most recent economic projections. CBO has calculated that distribution so that the projection of rates 

Average Cost (Per $100 in originations)

Policy Alternative

Estimated Using

Historic Interest Rates

Estimated Using

Projected Interest Rates

Consolidation at a fixed rate of the three-month Treasury bill rate 

plus 2.3 percentage points

$4.60 $1.50

Consolidation at a fixed rate of the 10-year Treasury note rate 

plus 2.3 percentage points

40 cents 40 cents

Consolidation at the variable rate on the original loan 60 cents 50 cents

Consolidation at a fixed rate of the three-month Treasury bill rate 

plus 3.3 percentage points

$2.80 70 cents

Consolidation at a fixed rate of the three-month Treasury bill rate 

plus 3.3 percentage points or at a variable rate of the annually 

adjusted three-month Treasury bill rate plus 2.3 percentage 

points 

$2.90 70 cents

12. If consolidation was not available, the cost of extending the term 

to maturity of the original 10-year variable-rate loan under existing extended repayment provisions would have averaged $2.70 

per $100 of originations, CBO estimates. Therefore, compared 

with the cost of the 10-year variable-rate loan, the total additional 

cost of a long-term fixed-rate loan (the cost of both the consolidation and extension options) averaged $7.30 per $100 of loans 

originated.

13. In that calculation, only those borrowers who cannot obtain 

longer maturities under the extended repayment provisions of the 

original loan will exercise the consolidation option. In that case, 

CBO estimates that consolidation will account for about 30 percent of the total dollar volume of loans that are either consolidated 

or extended.
6 THE COST OF THE CONSOLIDATION OPTION FOR STUDENT LOANS

begins at the current rates and implies a long-term rate 

that converges with CBO’s baseline projection of such 

rates.14 Consolidation, including the expanded option to 

extend a loan’s term to maturity under the rules for consolidated and unconsolidated loans scheduled to take 

effect in July 2006, will cost about 40 cents per $100 in 

loan principal originated, in CBO’s estimation. (That 

estimate also is not shown in Table 1, for the same reason 

as that given earlier.)

Those projected costs are lower than historic costs because the market conditions of the past several years—

with very low short-term interest rates and a wide gap 

between short- and long-term rates—have only a small 

likelihood of recurring over the next 10 years. 

The Costs of Consolidation Under 

Alternative Policies

At various times, the Congress has considered changing 

the interest rate on consolidated loans, including several 

alternatives to the current formula. Those alternatives 

would allow borrowers to consolidate their original 

variable-rate loans at a fixed rate, at a variable rate, or at a 

choice of either a fixed or variable rate. Since the passage 

of the Deficit Reduction Act of 2005, those alternatives 

may no longer be under consideration; nonetheless, they 

provide useful illustrations of the effects of various 

changes in terms on the cost of consolidation. 

The primary factor that determines the cost of consolidation under the alternatives considered in this analysis is 

the extent to which the interest rate at consolidation falls 

below the appropriate market-based rate. The estimated 

cost of consolidation assumes that original loans continue 

to have variable rates with extended repayment terms, as 

under the rules in effect before July 2006. Thus, the 

change in the cost of consolidation represents the relative 

cost of each of these alternatives. 

Consolidation at a Fixed Long-Term Interest Rate 

Under this alternative, an original variable-rate loan 

could be consolidated at a fixed interest rate—specifically, 

the rate on the 10-year Treasury note plus 2.3 percentage 

points—capped at 8.25 percent. The cost of consolidation would be 40 cents per $100 originated, CBO estimates (see Table 1). That cost is significantly lower than 

the cost of consolidation under current law (before July 

2006) and is comparable to the cost of consolidation at a 

variable rate because the fixed rate is linked to the appropriate market interest rate on long-term debt.

Consolidation at a Variable Interest Rate

This alternative is essentially the same as the option many 

borrowers had before July 2006 to extend the term to maturity of their variable-rate loans without consolidating. 

The loans would continue to have the same variable interest rate as under the original loans. Borrowers with 

total loan balances of less than $30,000 and those with 

loans from more than one lender would benefit from this 

option because it would allow them to extend the term to 

maturity of their loans and make one monthly payment. 

The cost of consolidation under this alternative would be 

60 cents per $100 using historic interest rates and 50 

cents per $100 using projected interest rates. Virtually all 

of the cost would stem from more borrowers becoming 

eligible to extend the term to maturity of their existing 

loans, which carry a below-market interest rate. In comparison with the cost of consolidation under terms in effect through June 2006, the costs under this alterative are 

significantly lower because the rate applied to the loans is 

reset annually on the basis of the change in the shortterm interest rate. 

Consolidation at a Fixed Short-Term Interest Rate 

Under this alternative, a variable-rate original loan could 

be consolidated at the rate on three-month Treasury bills 

plus 3.3 percentage points. This alternative is identical to 

the policy in effect through June 2006 except that the 

spread over the three-month Treasury bill rate applied to 

consolidated loans would be raised by 1 percentage point. 

Using historical interest rates, CBO estimates that the 

cost of this alternative would be $2.80 per $100 in loans 

originated, substantially less than the cost under the 

terms in effect through June 2006 because of the higher 

interest rate. Using projected interest rates, CBO estimates that this alternative would cost 70 cents per $100.

The cost of consolidation would be higher under this alternative than it would be if consolidation was indexed to 

the rate on 10-year Treasury securities—even though the 

markup on the three-month Treasury bill rate was 1 per14. For CBO’s latest interest rate projections, see Congressional Budget Office, The Budget and Economic Outlook: Fiscal Years 2007 to 

2016 (January 2006), Chapter 2.

CBO simulated future short-term Treasury rates using a CoxIngersoll-Ross one-factor model in which the mean value reverts 

to slightly above 5 percent.
THE COST OF THE CONSOLIDATION OPTION FOR STUDENT LOANS 7

centage point higher than the markup on the 10-year 

Treasury note rate—because this alternative would still 

enable borrowers to lock in a rate for a long-term loan 

that was indexed to a short-term rate. 

Consolidation at a Fixed or Variable Interest Rate 

Under this alternative, which was considered by the 

House of Representatives in 2005, borrowers could 

choose to consolidate their loans at a fixed or variable interest rate. If borrowers chose the fixed rate, they could 

consolidate their loans at the rate for three-month Treasury bills plus 3.3 percentage points. The terms are the 

same as in the previous alternative, as is the cost ($2.80 

per $100 in originations using historical interest rates). 

If borrowers chose the variable rate, the interest rate 

would fluctuate over the life of the consolidated loan at 

2.3 percentage points above the annually adjusted threemonth Treasury bill rate. However, under terms that are 

in effect through June 2006, many borrowers can obtain 

a long-maturity variable-rate loan at that spread by extending repayment without consolidating. Therefore, 

adding this choice increases the average cost very little.

Using historical interest rates, CBO estimates that the 

government’s cost for this alternative would be $2.90 per 

$100 of loans originated. Using projected interest rates, 

CBO puts the cost at 70 cents per $100, the same as in 

the previous alternative. The cost of consolidation under 

this alternative is lower than the cost under terms in effect 

through June 2006 primarily because the fixed rate is 1 

percentage point higher.15 But consolidation is still costly 

under this alternative because the fixed interest rate is not 

indexed to a long-term market interest rate.

15. Most of the volume of loans consolidated could have instead been 

extended at a variable rate under the extended repayment plan. 

Therefore, from a borrower’s perspective, a consolidation policy 

that allowed a choice between a fixed rate and a variable rate 

would not significantly differ from current policy, which allows 

only a fixed rate when consolidating.

APPENDIX

A

Assumptions Underlying the

Cost Estimates in This Analysis

The assumptions underlying the cost estimates in 

this analysis are important to their interpretation. In addition, many of the values required to calculate the costs 

of student loan consolidation are highly uncertain. Except as noted, the assumptions are the same for both the 

direct and guaranteed loan programs. The sensitivity of 

the cost estimates to alternative assumptions is reported 

at the end of this appendix.

Interest Rates 

Differences between short- and long-term interest rates 

have a large effect on the estimated costs of consolidation. 

The Congressional Budget Office (CBO) has estimated 

costs of the student loan program under two scenarios for 

the distribution of interest rates. One scenario is based on 

historical interest rates from the past 20 years, and the 

other is based on projected interest rates, as reported in 

CBO’s latest Budget and Economic Outlook.

1 In both scenarios, the variability of interest rates is estimated from 

the annual variation in short-term Treasury rates over the 

past 20 years; long-term rates are based on the averages 

of projected short-term rates in future years. Over the 

past 20 years, the average long-term interest rate has been 

almost 7 percent, about 2 percentage points higher than 

the short-term rate. Over the next 10 years, however, the 

average long-term interest rate is projected to be about 

5.5 percent, about half a percentage point higher than the 

projected average for the short-term rate. 

Administrative Costs

In the guaranteed loan program, lenders are responsible 

for paying most administrative costs. In the direct loan 

program, however, the government pays those costs directly to employees and contractors. Because data on the 

total administrative costs for the direct loan program are 

not available, CBO assumes—on the basis of comparable 

market prices—that those costs are 50 basis points per 

year per dollar of outstanding direct loans.

Rates of Consolidation 

Since 1998, borrowers have consolidated 70 percent of 

their outstanding student loans, on average; that amount 

has varied significantly over time, from a low of 40 percent in 2000 to a peak of more than 80 percent in 2004.2

The rate of consolidation has been highest when the gains 

to borrowers from consolidation are also high.3 Thus, 

under current law, the frequency of consolidation and 

accompanying term extension in any year increases with 

borrowers’ gains from consolidation in that year. 

CBO attributes the link between interest rates and rates 

of consolidation to the ability of borrowers to lock in a 

variable rate rather than their ability to extend the term to 

maturity of their loans. In evaluating policy alternatives 

in which the interest rate at consolidation does not vary 

over time, CBO assumes that a constant 40 percent of 

eligible borrowers will consolidate. Furthermore, for all 

loans that are consolidated or have their term to maturity 

extended, CBO assumes that those activities will occur 

1. See Congressional Budget Office, The Budget and Economic Outlook: Fiscal Years 2007 to 2016 (January 2006).

2. The consolidation participation rate for a given year is determined 

by dividing the value of loans consolidated in that year by the 

average amount of loans originated over the preceding five years. 

3. The gains to borrowers and government’s costs of consolidation 

are the difference between the present value of the original loan 

and the present value of the consolidated loan. That value approximates the value received by borrowers from exercising the option 

to consolidate immediately.
10 THE COST OF THE CONSOLIDATION OPTION FOR STUDENT LOANS

just before or just after repayment of the original loans 

begins.4

Because term extension is not a feature that is unique to 

consolidated loans, CBO had to make an assumption 

about the fraction of borrowers who would extend the 

term to maturity of their loans if consolidation was not 

available. In CBO’s estimation, 40 percent of eligible borrowers would exercise the extended repayment provisions 

of their existing loans if consolidation was not available. 

That figure is symmetrical with the assumed rate of consolidation when borrowers do not have the right to lock 

in a short-term variable rate because term extension and 

consolidation are close substitutes for each other.

Defaults

The Department of Education reports annually on default rates by loan cohort. In recent years, cumulative 

two-year and lifetime default rates on original loans have 

been about 5 percent and 15 percent, respectively.5

 Recovery of defaulted loans is very high in an accounting 

sense, as the majority of borrowers who default eventually 

repay the outstanding principal, accrued interest, and any 

penalties. However, the significant administrative costs of 

recovery, the delay in recovering amounts from defaulted 

loans, the continuation of favorable interest-rate terms, 

and the write-off of some uncollectible loans suggest that 

the economic rate of recovery from default is less than 70 

percent of the principal outstanding at the time of default. In addition to the direct costs of default, the department incurs significant expenses offering forbearance and 

deferment to borrowers in financial difficulty. 

Rather than model the complex interaction between forbearance, default, and recovery, CBO assumes a constant 

annual rate of default adjusted for recovery and forbearance of 1 percent per year.6 If CBO used a default rate 

that was 0.5 percent per year higher or lower, the estimated cost of consolidation would change by less than 25 

cents per $100 in loan originations. 

Discount Rates

The discount rate applied to cash flows is composed of a 

rate appropriate to default-free cash flows obtained from 

Treasury interest rates and a spread for the market risk associated with default. The private market for student 

loans offers one source of information about the likely 

magnitude of the market risk premium. Variable-rate student loans offered by private lenders have interest rates 

that range from 3 to 7 percentage points above shortterm Treasury rates, depending on a borrower’s credit history and job prospects. For a typical borrower, market 

rates are usually about 4 to 5 percentage points higher 

than short-term Treasury rates. However, in addition to 

incorporating a premium for market risk, the spread on 

Treasury rates includes administrative costs and the value 

of expected losses from defaults. CBO calculates that the 

market risk of the loans is 2 percentage points, on the basis of the assumption of a 4 percentage point spread over 

the short-term U.S. Treasury rate, a 1 percentage point 

annual cost of administration (including marketing and 

servicing), and a 1 percentage point loss from expected 

defaults. 

To test for the sensitivity of the results to those assumptions, CBO reestimated the cost of the consolidation 

option with discount rates that were 1 percentage point 

higher and 1 percentage point lower. In each case, the 

cost estimates changed by about 50 cents per $100. 

Other Assumptions

This analysis does not include the effects of loan prepayments, deferments, or forbearance. The estimate of the 

ratio of loans in the direct versus guaranteed loan programs is based on the average over the past 10 years. The 

mix of loan maturities that borrowers select upon consolidation and borrowers’ choices about consolidating during the grace period are based on data obtained from 

private lenders and the Department of Education.

4. Under current law, when a borrower consolidates during the grace 

period before repayment begins, he or she locks in the in-school 

interest rate, which is 0.6 percentage points lower than the rate in 

regular repayment. CBO estimates that approximately 40 percent 

of borrowers will obtain that discount, an assumption that it 

includes in its estimated costs of consolidation. 

5. The Department of Education declares borrowers to be in default 

after they are more than 270 days behind in their monthly payments, a definition that is more generous to borrowers than that 

used by private lenders. In addition, the reported cohort and lifetime default rates for original loans do not include defaults that 

occur after borrowers consolidate their loans. The Department of 

Education estimates a lifetime default rate of approximately 20 

percent on consolidated loans.

6. On an annual basis, two-year cohort default rates are significantly 

higher than lifetime cohort default rates, which would seem to 

indicate that default rates vary with the age of a loan. There is 

insufficient data to model variation in default rates by loan age, 

however.
APPENDIX

B

The Economics of the Consolidation Option

Under terms in effect through June 2006, when 

borrowers consolidate their student loans, they can lock 

in the prevailing short-term interest rate for the life of the 

loan. In the private market, that option would be available only in exchange for a considerable premium, because the cost of lending at a fixed rate of interest over a 

long period includes current as well as future short-term 

interest rates (and any risks associated with them). As a 

result, market-determined long-term interest rates capture the market’s expected path for short-term rates plus a 

term premium.

The consequences of lending at fixed interest rates tied to 

short-term rates can be illustrated with a simple example. 

Consider the three sets of prevailing interest-rate conditions shown in Figure B-1. Each diagram shows the interest rate over various loan maturities, a relationship referred to as the term structure of interest rates or, 

alternatively, the yield curve. The first case—an upwardsloping yield curve—reflects the market’s expectation that 

short-term interest rates will rise in the future. The second and third cases—flat and downward-sloping yield 

curves, respectively—reflect the market’s expectation of 

no change in short-term interest rates or falling shortterm interest rates.1

Consider the present value of an original loan with a 

floating interest rate and a consolidated loan with a fixed 

interest rate. For simplicity, assume that both loans have 

the same term to maturity and ignore the interest rate cap 

on such loans. A floating-rate loan tied to short-term interest rates will hold its value despite any changes in 

short-term interest rates. As interest rates rise, the future 

value of promised cash flows tends to fall, but that decline 

is offset by the increase in interest paid on the loan. Thus, 

a $100 student loan might have a present value of $85 in 

Figure B-1.

The Market Value of a $100 Loan

Source: Congressional Budget Office.

all three interest-rate scenarios. (The constant difference 

between the amount of the loan and its present value reflects the fact that the interest rate charged is insufficient 

to cover the cost of the loan.) 

In contrast, the same loan with an interest rate fixed at 

the prevailing short-term rate will vary in its present value 

depending on the shape of the original yield curve. When 

the yield curve is upward sloping, the borrower obtains a 

fixed rate significantly below the longer-term rate that reflects expected short-term interest rates, making the loan 

1. The figure does not include the term premium in long-term 

interest rates.

4

0

0

0

5

6

4

5

6

Initial Yield Curve

(Percent)

Original

Floating

Rate

Consolidation

at Short-Term

Rate

Upward Sloping

Flat

Downward Sloping

$85 $75

$85 $85

$85 $95

4

5

6

Term to Maturity
12 THE COST OF THE CONSOLIDATION OPTION FOR STUDENT LOANS

less valuable than the original variable-rate loan ($75, as 

indicated in Figure B-1). For a flat yield curve, there is no 

difference in value between the fixed and variable rates 

because the interest rate locked in coincides with the 

long-term rate. The downward-sloping yield curve would 

make the fixed-rate loan more valuable than the variablerate loan because the loan would carry a rate that exceeds 

the prevailing long-term rate. 

The difference in value between a fixed-rate loan and a 

variable-rate loan is the cost of consolidation at the time 

of its exercise under the prevailing interest rate conditions. If consolidation was equally likely under all three 

yield-curve scenarios, one might expect that, on average, 

the cost of providing the consolidation option would be 

near zero. But the incentives to the borrower holding the 

option suggest that when a fixed-rate loan is most valuable to the lender (case 3), it is least desirable to the borrower, so the option is less likely to be exercised. A borrower is most likely to exercise the consolidation option 

when the yield curve is upward sloping and least likely 

when the yield curve is downward sloping. On average, 

the consolidation option thus imposes a financial cost on 

the government even if all three yield curves are equally 

likely.2

 In purely private markets, lenders would offer 

only fixed-rate consolidation loans that were indexed to a 

longer-term interest rate because they could lose money 

otherwise.

2. In fact, upward-sloping yield curves are more frequent than 

downward-sloping ones. Thus, even if borrowers consolidate at 

random without regard to the benefit of doing so, consolidation 

will be costly to the government.

INSIDE MAIL

CONGRESS OF THE UNITED STATES

CONGRESSIONAL BUDGET OFFICE

WASHINGTON, DC 20515