Student Loan Programs: Lower Interest Rates and Higher Loan Volume Have Increased Federal Consolidation Loan Costs
Published: 2004-03-17T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Consolidation loans, available under the Department of Education's (Education) two major student loan programs--the Federal Family Education Loan Program (FFELP) and the William D. Ford Direct Loan Program (FDLP)--help borrowers manage their student loan debt. By combining multiple loans into one loan and extending the repayment period, a consolidation loan reduces monthly repayments, which may lower default risk and, thereby, reduce federal costs of loan defaults. Consolidation loans also allow borrowers to lock in a fixed interest rate, an option not available for other student loans. Consolidation loans under FFELP and FDLP accounted for about 48 percent of the $87.4 billion in total new student loan dollars that originated during fiscal year 2003. Two main types of federal cost pertain to consolidation loans. One is "subsidy"--the net present value of cash flows to and from the government that result from providing these loans to borrowers. For FFELP consolidation loans, cash flows include, for example, fees paid by lenders to the government and a special allowance payment by the government to lenders to provide them a guaranteed rate of return on the student loans they make. For FDLP consolidation loans, cash flows include borrowers' repayment of loan principal and payments of interest to Education, and loan disbursements by the government to borrowers. The subsidy costs of FDLP consolidation loans are also affected by the interest Education must pay to the Department of Treasury (Treasury) to finance its lending activities. The second type of cost is administration, which includes such items as expenses related to originating and servicing direct loans. This testimony focuses on two key issues: (1) recent changes in interest rates and consolidation loan volume and (2) how these changes have affected federal costs for FFELP and FDLP consolidation loans.
section_title: What GAO Found
paragraphs: Recent years have seen a drop in interest rates for student loan borrowers along with dramatic overall growth in consolidation loan volume. From July 2000 to June 2003, the interest rate for consolidation loans dropped by more than half, with consolidation loan borrowers obtaining rates as low as 3.50 percent as of July 1, 2003. From fiscal year 1998 through fiscal year 2003, the volume of consolidation loans made (or "originated") rose from $5.8 billion to over $41 billion. The dramatic growth in consolidation loan volume in recent years is due in part to declining interest rates that have made it attractive for many borrowers to consolidate their variable rate student loans at a low, fixed rate. Recent trends in interest rates and consolidation loan volume have affected the cost of the FFELP and FDLP consolidation loan programs in different ways, but in the aggregate, estimated subsidy and administration costs have increased. For FFELP consolidation loans, subsidy costs grew from $0.651 billion for loans made in fiscal year 2002 to $2.135 billion for loans made in fiscal year 2003. Both higher loan volumes and lower interest rates available to borrowers in fiscal year 2003 increased these costs. Lower interest rates increase these costs because FFELP consolidation loans carry a government-guaranteed rate of return to lenders that is projected to be higher than the fixed interest rate paid by consolidation loan borrowers. When the interest rate paid by borrowers does not provide the full guaranteed rate to lenders, the federal government must pay lenders the difference. FDLP consolidation loans are made by the government and thus carry no interest rate guarantee to lenders, but changing interest rates and loan volumes affected costs in this program as well. In both fiscal years 2002 and 2003, there was no net subsidy cost to the government because the interest rate paid by borrowers who consolidated their loans was greater than the interest rate Education must pay to the Treasury to finance its lending. However, the drop in loan volume and interest rates that occurred in fiscal year 2003, contributed to cutting the government's estimated net gain from $570 million in fiscal year 2002 to $543 million for loans made in fiscal year 2003. Administration costs are not specifically tracked for either consolidation loan program, but available evidence indicates that these costs have risen, primarily reflecting increased overall loan volumes.

section_title: Letter
paragraphs: lenders; a sample of student loan data extracted from Education’s National  Student Loan Data System (NSLDS)—a comprehensive national database  of student loans, borrowers, and other information; relevant cost analyses  prepared by Education; and statutory, regulatory and other published  information. For this testimony, we updated our numbers to reflect recent  estimates made by the Department of Education. Our work was conducted  in accordance with generally accepted government auditing standards.
Recent years have seen a drop in interest rates for student loan borrowers  along with dramatic overall growth in consolidation loan volume. From  July 2000 to June 2003, the interest rate for consolidation loans dropped by  more than half, with consolidation loan borrowers obtaining rates as low  as 3.50 percent as of July 1, 2003. From fiscal year 1998 through fiscal year  2003, the volume of consolidation loans made (or “originated”) rose from  $5.8 billion to over $41 billion. The dramatic growth in consolidation loan  volume in recent years is due in part to declining interest rates that have  made it attractive for many borrowers to consolidate their variable rate  student loans at a low, fixed rate.
Recent trends in interest rates and consolidation loan volume have  affected the cost of the FFELP and FDLP consolidation loan programs in  different ways, but in the aggregate, estimated subsidy and administration  costs have increased. For FFELP consolidation loans, subsidy costs grew  from $0.651 billion for loans made in fiscal year 2002 to $2.135 billion for  loans made in fiscal year 2003. Both higher loan volumes and lower  interest rates available to borrowers in fiscal year 2003 increased these  costs. Lower interest rates increase these costs because FFELP  consolidation loans carry a government-guaranteed rate of return to  lenders that is projected to be higher than the fixed interest rate paid by  consolidation loan borrowers. When the interest rate paid by borrowers  does not provide the full guaranteed rate to lenders, the federal  government must pay lenders the difference. FDLP consolidation loans are  made by the government and thus carry no interest rate guarantee to  lenders, but changing interest rates and loan volumes affected costs in this  program as well. In both fiscal years 2002 and 2003, there was no net  subsidy cost to the government because the interest rate paid by  borrowers who consolidated their loans was greater than the interest rate  Education must pay to the Treasury to finance its lending. However, the  drop in loan volume and interest rates that occurred in fiscal year 2003,  contributed to cutting the government’s estimated net gain from $570  million in fiscal year 2002 to $543 million for loans made in fiscal year  2003. Administration costs are not specifically tracked for either  consolidation loan program, but available evidence indicates that these  costs have risen, primarily reflecting increased overall loan volumes.
In our prior report, we recommended that the Secretary of Education  assess the advantages of consolidation loans for borrowers and the  government in light of program costs and identify options for reducing  federal costs.  Education agreed with our recommendation.
subsections: section_title: Background
paragraphs: Consolidation loans differ from other loans in the FFELP and FDLP  programs in that they enable borrowers who have multiple loans— possibly from different lenders, different guarantors, and even from  different loan programs—to combine their loans into a single loan and  make one monthly payment. By obtaining a consolidation loan, borrowers  can lower their monthly payments by extending the repayment period  longer than the maximum 10 years generally available on the underlying  loans. Maximum repayment periods allowed vary by the amount of the  consolidation loan (see table 1). Consolidation loans also provide  borrowers with the opportunity to lock in a fixed interest rate on their  student loans, based on the weighted average of the interest rates in effect  on the loans being consolidated rounded up to the nearest one-eighth of 1  percent, capped at 8.25 percent. Borrowers can qualify for consolidation  loans regardless of financial need. Loans eligible for inclusion in a  consolidation loan must be comprised of at least one eligible FFELP or  FDLP loan, including subsidized and unsubsidized Stafford loans, PLUS  loans, and, in some instances, consolidation loans. Both subsidized and  unsubsidized Stafford loans, and PLUS loans are variable rate loans. Other  types of federal student loans made outside of FFELP and FDLP, which  may carry a variable or fixed borrower interest rate, are also eligible for  inclusion in a consolidation loan, including Perkins loans, Health  Professions Student loans, Nursing Student Loans, and Health Education  Assistance loans (HEAL).
The Federal Credit Reform Act (FCRA) of 1990 helps define federal costs  associated with consolidation loans and was enacted to require agencies,  including Education, to more accurately measure federal loan program  costs. Under FCRA, Education is required to estimate the long-term cost to  the government of a direct loan or a loan guarantee—generally referred to  as the subsidy cost. Subsidy cost estimates are calculated based on the  present value of estimated net cash flows to and from the government that  result from providing loans to borrowers. For FFELP consolidation loans,  cash flows include, for example, fees paid by lenders to the government  and a special allowance payment by the government to lenders to provide  them a guaranteed rate of return on the student loans they make. For  FDLP consolidation loans, cash flows include borrowers’ repayment of  loan principal and payments of interest to Education, and loan  disbursements by the government to borrowers. Unlike FFELP, FDLP  involves no guaranteed yields or special allowance payments to lenders  because the program is a direct loan program. The subsidy costs of FDLP  consolidation loans are also affected by the interest Education must pay to  Treasury to finance its lending activities. Another type of cost pertaining to  consolidation loans is administration, which includes such items as  expenses related to originating and servicing direct loans.
In estimating loan subsidy costs, Education first estimates the future  economic performance (net cash flows to and from the government) of  direct and guaranteed loans when preparing its annual budgets. These first  estimates establish the subsidy estimates for the current-year originated  loans. The data used for the first estimates are reestimated in later years to  reflect any changes in actual loan performance and expected changes in  future performance. Reestimates are necessary because projections about  interest and default rates and other variables that affect loan program  costs change over time. Any increase or decrease in the estimated subsidy  cost results in a corresponding increase or decrease in the estimated cost  of the loan program for both budgetary and financial statement purposes.
section_title: Borrowers’ Rates Have Dropped, and Loan Volume Has Risen
paragraphs: Recent years have seen a drop in interest rates for student loan borrowers  along with dramatic overall growth in consolidation loan volume. From  July 2000 to June 2003, the interest rate for consolidation loans dropped by  more than half, with consolidation loan borrowers obtaining rates as low  as 3.50 percent as of July 1, 2003. From fiscal year 1998 through fiscal year  2003, the volume of consolidation loans made (or originated) rose from  $5.8 billion to over $41 billion. Over four-fifths of the fiscal year 2003 loan  volume is in FFELP. While overall volume rose in 2003, the trends differed  by program. FDLP consolidation loan volume for fiscal year 2003  decreased, but loan volume in the larger FFELP increased, resulting in  total consolidation loan volume of well over $41 billion.
The dramatic growth in consolidation loan volume in recent years is due in  part to declining interest rates that have made it attractive for many  borrowers to consolidate their variable rate student loans at a low, fixed  rate. Figure 1 shows the relationship between these two factors. When  interest rates are low, some borrowers may find it in their economic self- interest to consolidate their loans so that they can lock in a low fixed  interest rate for the life of the loan, as opposed to paying variable rates on  their existing loans, regardless of whether they need a consolidation loan  to avoid difficulty in making loan repayments and avert default.
Underscoring the potential attractiveness of these loans to potential  borrowers, many lenders, including newer loan companies that are  specializing in consolidation loans, have aggressively marketed  consolidation loans to compete for consolidation loan business as well as  to retain the loans of their current customers. Their marketing techniques  have included mass mailings, telemarketing, and Internet pop-ups to  encourage borrowers to consolidate their loans. This increased marketing  effort has likely contributed to the record level of consolidation loan  volume.
section_title: Changes in Interest Rates and Loan Volume Affect FFELP and FDLP Costs in Different Ways, but in the Aggregate, Estimated Costs Increased
paragraphs: While the estimated future costs for consolidation loans can vary greatly  from year to year, low interest rates and recent loan volume changes have  resulted in substantial increases in overall costs to the federal government.  However, in light of the differences between how FFELP and FDLP  operate, the subsidy costs within these two programs were affected in very  different ways. For FFELP, the result was a substantial increase. For  FDLP, the result was a narrowing of the net difference between the  estimated interest payments paid by consolidated loan borrowers to  Education and the costs paid by Education to Treasury to finance direct  loans.
subsections: section_title: FFELP Subsidy Costs Affected by Increased Special Allowance Payments to Lenders and Increased Loan Volume
paragraphs: Estimated subsidy costs for FFELP consolidation loans rose from $0.651  billion for loans made in fiscal year 2002 to $2.135 billion for loans made in  fiscal year 2003. The increase is largely due to the higher interest subsidies  the government is expected to pay to lenders to ensure they receive a  guaranteed rate of return on student loans and the result of greater loan  volume. The interest subsidy, which is called a special allowance payment  (SAP), is based on a formula specified in law and paid by Education to  lenders on a quarterly basis when the “guaranteed lender yield” exceeds  the borrower rate. This guaranteed lender yield is currently based on the  average 3-month commercial paper interest rate plus an additional 2.64  percent. When this guaranteed yield is higher than the amount of interest  being paid by borrowers, Education makes up the difference. If the  borrower’s interest rate exceeds the guaranteed lender yield, Education  does not pay a SAP, and the lender receives the borrower rate.
Education’s estimate of $2.135 billion in subsidy costs for FFELP  consolidation loans made in fiscal year 2003 is based on the assumption  that the guaranteed lender yield will rise over the next several years,  reflecting Education’s assumption that market interest rates are likely to  rise from the historically low levels experienced in fiscal year 2003. The  effect of this rise is shown in figure 2, where the bottom line shows the  fixed borrower rate for a FFELP consolidation loan made in the first 9  months of fiscal year 2003, and the top line shows Education’s estimated  values for the guaranteed lender yield over time. In fiscal year 2003,  market interest rates were such that the guaranteed lender yield  established under the SAP formula was actually below the borrower rate.  Lenders, therefore, received only the rate paid by borrowers; no SAP was  paid. However, in future years, when the guaranteed lender yield is  expected to increase and be above the borrower rate, Education would  have to make up the difference in the form of a SAP. As figure 2 shows,  Education’s assumptions would call for lenders to receive a SAP over most  of the life of the consolidation loans made in fiscal year 2003.
An increase in loan volume also played a role in the subsidy cost increase  from fiscal years 2002 to 2003. However, the effect of the increased loan  volume was not as large as that of the higher interest subsidies the  government is expected to pay to lenders in the future.
section_title: FDLP Loans also Affected by Changing Interest Rates
paragraphs: Subsidy costs can occur within FDLP as well, but in a different way.  FDLP’s consolidation program is a direct loan program and, therefore,  involves no guaranteed yields to private lenders. Still, the program has  potential subsidy costs if the government’s cost of borrowing is higher  than the interest rate borrowers are paying. The government’s cost of  borrowing is determined by the interest rate Education pays Treasury to  finance direct student loans, which is equivalent to the discount rate. The  difference between borrowers’ rates and the discount rate—called the  interest rate spread—is a key driver of subsidy estimates for FDLP loans.  When the borrower rate is greater than the discount rate, Education will  receive more interest from borrowers than it will pay in interest to  Treasury to finance its loans, resulting in a positive interest rate spread— or a gain (excluding administrative costs) to the government. Conversely,  when the borrower rate is less than the discount rate, Education will pay  more in interest to Treasury than it will receive from borrowers, which  will result in a negative interest rate spread—or a cost to the government.
For FDLP consolidation loans made in fiscal years 2002 and 2003, no such  negative interest rate spreads were incurred in either year, based on the  methodology Education uses to determine these costs. In both years,  borrower interest rates for FDLP consolidation loans were somewhat  higher than the discount rate, resulting in a net gain to the government.  However, while Education continued to benefit from lending at interest  rates higher than its cost of borrowing for FDLP consolidation loans made  in fiscal year 2003, the size of this benefit declines from $571 million in  fiscal year 2002 to $543 million in fiscal year 2003.
The smaller net gain that occurred in fiscal year 2003 reflects both a  decrease in the loan volume and a narrowed difference between the  discount rate and the borrower rate. Loan volume in fiscal year 2003 was  $6.7 billion, a decrease from $8.8 billion in fiscal year 2002. In fiscal year  2003, this difference narrowed in part because borrower rates dropped  more than the discount rate. The borrower rates for FDLP consolidation  loans dropped 1.2 percentage points, from 6.3 percent in fiscal year 2002 to  5.1 percent in fiscal year 2003. The discount rate, on the other hand,  dropped by only 0.88 percentage points, from 4.72 percent in fiscal year  2002 to 3.84 percent in fiscal year 2003. The resulting interest rate spread  decreased from 1.59 percent to 1.22 percent (see table 2). In other words,  each $100 of consolidated FDLP loans made in fiscal year 2002, will result  in $1.59 more in interest received by Education than it will pay out in  interest to the Treasury. A similar loan originated in fiscal year 2003,  however, will generate only $1.22 more in interest for the government.
section_title: Administration Costs also Increase, Mainly because of Loan Volume
paragraphs: Loan volume affects administrative costs, in that cost is in part a function  of the number of loans originated and serviced during the year. As a result,  when loan volume increases, administration costs also increase.  Education’s current cost accounting system does not specifically track  administration costs incurred by each of the student loan programs.  Consequently, we were unable to determine the total administration costs  incurred by consolidation loan programs or any off-setting administrative  cost reductions associated with the prepayment of loans underlying  consolidation loans. However, based on available Education data, we were  able to determine some of the direct costs associated with the origination,  servicing, and collection of FDLP consolidation loans. For fiscal year 2002,  these costs totaled roughly $52.3 million. This does not include overhead  costs, which include costs incurred for personnel, rent, travel, training,  and other activities related to maintaining program operations. For fiscal  year 2003, the estimated costs for the origination, servicing, and collection  of FDLP consolidation loans is projected to increase to $59.5 million.  While we similarly were unable to determine Education’s administration  costs directly related to FFELP consolidation loans, they are likely to be  smaller than for FDLP consolidation loans. This is because a large portion  of FFELP administration cost is borne directly by lenders, who make and  service the loans. The special allowance payments to lenders, which rise  and fall as interest rates change, are designed to ensure that lenders are  compensated for administration and other costs and provided with a  reasonable return on their investment so that they will continue to  participate in the program.
section_title: Concluding Observations
paragraphs: As the discussion of both FFELP and FDLP loans shows, interest rates  have a strong effect on whether subsidy costs occur and how large they  are. The movement of subsidy costs for consolidation loans made in future  years will depend heavily on what happens to interest rates. As we have  shown, subsidy cost estimates for FFELP consolidation loans can increase  substantially, depending on how much the guaranteed lender yield rises  above the fixed rate paid by borrowers, which, in turn, requires the federal  government to pay subsidies to lenders. Conversely, if borrowers obtained  consolidation loans with a fixed interest rate at a time when rates were  expected to decrease in the future, federal subsidy costs could be lower,  than is currently the case, because the borrower rate could exceed the rate  guaranteed to lenders, and the federal government might not be required  to pay lender subsidies. For FDLP consolidation loans, allowing borrowers  to lock in a low fixed rate might result in decreased federal revenues if the  variable interest rates on those loans borrowers converted to a  consolidation loan would have otherwise increased in the future. The  exact effects of FDLP consolidation loans, however, depend on a number  of factors, including the length of loan repayment periods, borrower  interest rates, and discount rates.
We noted in our prior report that borrowers’ choices between obtaining a  fixed rate consolidation loan or retaining their variable rate loans can  significantly affect federal costs. While consolidation loans may be an  important tool to help borrowers manage their educational debt and thus  reduce the cost of student loan defaults, the surge in the number of  borrowers consolidating their loans suggests that many borrowers who  face little risk of default are choosing consolidation as a way of obtaining  low fixed interest rates—an economically rational choice on the part of  borrowers. If borrowers continue to consolidate their loans in the current  low interest rate environment, and interest rates rise, the government  assumes the cost of larger interest subsidies. Providing for these larger  interest subsidies on behalf of a broad spectrum of borrowers may  outweigh any government savings associated with the reduced costs of  loan defaults for the smaller number of borrowers who might default in  the absence of the repayment flexibility offered by consolidation loans.
In our October 2003 report, we also discussed the extent to which  repayment options other than consolidation loans allow borrowers to  simplify loan repayment and reduce repayment amounts. We found that  other repayment options that allow borrowers to make a single payment to  cover multiple loans and smaller monthly payments are now available for  some borrowers under both FFELP and FDLP, but these alternatives are  not available to all borrowers. In that report, we concluded that  restructuring the consolidation loan program to specifically target  borrowers who are experiencing difficulty in managing their student loan  debt and at risk of default, and/or who are unable to simplify and reduce  repayment amounts by using existing alternatives, might reduce overall  federal costs by reducing the volume of consolidation loans made. In  addition, making the other nonconsolidation options more readily  available to borrowers might be a more cost-effective way for the federal  government to provide borrowers with repayment flexibility while  reducing federal costs. An assessment of the advantages of consolidation  loans for borrowers and the government, taking into account program  costs and the availability of, and potential change to, existing alternatives  to consolidation, and how consolidation loan costs could be distributed  among borrowers, lenders, and the taxpayers, would be useful in making  decisions about how best to manage the consolidation loan program and  whether any changes are warranted.
In our October 2003 report, we recommended that the Secretary of  Education assess the advantages of consolidation loans for borrowers and  the government in light of program costs and identify options for reducing  federal costs. We suggested options that could include targeting the  program to borrowers at risk of default, extending existing consolidation  alternatives to more borrowers, and changing from a fixed to a variable  rate the interest charged to borrowers on consolidation loans. We also  noted that, in conducting such an assessment, Education should also  consider how best to distribute program costs among borrowers, lenders,  and the taxpayers and any tradeoffs involved in the distribution of these  costs. Furthermore, if Education determines that statutory changes are  needed to implement more cost-effective repayment options, we believe it  should seek such changes from Congress.  Education agreed with our  recommendation.
Mr. Chairman, this concludes my prepared statement. I would be pleased  to respond to any questions that you or other members of the Committee  may have.
section_title: GAO Contact and Acknowledgments
paragraphs: For further contacts regarding this testimony, please call Cornelia M.  Ashby at (202) 512-8403. Individuals making key contributions to this  testimony include Jeff Appel, Susan Chin, Cindy Decker, and Julianne  Hartman-Cutts.
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