Direct Student Loans: Additional Steps Would Increase Borrowers' Awareness of Electronic Debiting and Reduce Federal Administrative Costs
Published: 2002-03-29T00:00:00

Fast Facts:

Highlights:
section_title: What GAO Found
paragraphs: Since 1999, the Department of Education (Education) has offered a 0.25 percent interest rate reduction to borrowers who agree to an electronic debit (EDA) program. Borrowers pay a lower interest rate, while the federal government receives fewer late payments. Any revenue loss to the federal government from a reduced interest rate would be more than offset by a gain in revenue because some EDA borrowers who had previously paid by check would stop making periodic payments in excess of their scheduled amount due. By ceasing to make these prepayments, these borrowers would not pay off their loans as soon as they would have without signing up for EDA and, therefore, incur additional interest costs over the life of their loans. Although actual EDA enrollments have exceeded original estimates, Education lacks data on prepayment patterns after borrowers enroll in the program. Education has not informed borrowers of the cost implications of EDA participation, nor has it systematically informed borrowers of their prepayment options. GAO estimates that Education saved $1.5 million in administrative costs in fiscal year 2001 because it did not have to mail bills to EDA borrowers.

section_title: Letter
paragraphs: In November 1999, the Department of Education (Education) began  offering a 0.25 percent interest rate reduction under the William D. Ford  Federal Direct Loan Program (FDLP) to borrowers who agree to have  their monthly loan payments automatically withdrawn from a bank  account via its electronic debit account (EDA) program. While borrowers  would benefit by paying a reduced interest rate on their loans, the federal  government would benefit from receiving fewer late payments. The Higher  Education Act of 1965, as amended, requires that such interest rate  reductions be “cost neutral and in the best financial interest of the Federal  Government” and that Education offset any higher subsidy costs resulting  from the interest rate reduction through reductions in funding for  administrative costs.
In a cost justification it submitted to the Congress in August 1999,  Education stated that the loss of revenue to the federal government from  offering the reduced interest rate would be more than offset by a gain in  revenue because some EDA borrowers who had previously paid by check  would stop making periodic payments in excess of their scheduled amount  due. By ceasing to make these prepayments, these borrowers would not  pay off their loans as soon as they would have without signing up for EDA  and, therefore, incur additional interest costs over the life of their loans.  Education assumed about half of the borrowers making prepayments prior  to enrolling in EDA would discontinue making prepayments after enrolling  in EDA. Education found that eliminating these prepayments could  potentially extend the time some borrowers were repaying their loans by  1-½ years. In effect, EDA borrowers who stopped prepaying would lose  some portion of their interest savings from the rate reduction. Thus,  Education’s analysis appeared to justify savings to the government at  additional cost to some borrowers enrolling in the EDA program, rather  than by reducing administrative costs associated with processing  payments by check. Because of your concern about the possibility that  some borrowers would pay additional interest under EDA, you asked us to  determine the following:
To what extent have assumptions concerning borrower behavior used in  Education’s cost justification materialized?
To what extent has Education informed borrowers of the possible cost  implications of EDA participation and the options that are available to  them for prepaying their loans?
To what extent has Education achieved administrative cost savings as a  result of the program?
In conducting this work, we interviewed Education officials and collected  and analyzed cost and other pertinent information. To examine the extent  to which Education’s cost justification assumptions about borrower  behavior—the percentage of EDA borrowers that would enroll in EDA and  the percentage that would change their prepayment patterns after  enrolling—materialized, we reviewed Education’s cost justification,  discussed its preparation and methodology with the Education officials  who developed it, and obtained and analyzed available information about  the repayment behavior of borrowers who have enrolled in the EDA  program. To identify the information Education had provided borrowers  about possible cost implications of EDA participation and prepayment  options associated with EDA, we obtained and reviewed all Education  direct loan repayment information available to borrowers. To estimate  administrative cost savings, we reviewed Education and Department of the  Treasury (Treasury) cost data associated with billing EDA and non-EDA  borrowers and processing their payments. We discussed our analysis with  officials at both agencies to ensure that we included all appropriate cost  items. We conducted our work between March 2001 and February 2002 in  accordance with generally accepted government auditing standards.
subsections: section_title: Background
paragraphs: The FDLP legislation was enacted in August 1993 as part of a broader  reform of the federal student loan programs.  The first direct loans were  made in fiscal year 1994.  FDLP makes it possible for students and their  families to borrow directly from the federal government through the  colleges or other postsecondary institutions the students attend. As of  September 30, 2001, about 3.6 million borrowers were repaying more than  $45 billion in direct loans. Education services FDLP loans through a  contract with Affiliated Computer Services, Inc. (ACS), an information  technology systems and services company. As prime contractor, ACS has  overall responsibility for FDLP loan servicing. ACS has a subcontract with  Academic Financial Services Association Data Corporation (AFSA), under  which AFSA has the main responsibility for FDLP loan-servicing  operations.  Education has an interagency agreement with Treasury for  processing direct loan payments. Treasury, in turn, has agreements with  and compensates certain commercial banks for processing both paper and  electronic payments made by the public to federal agencies. Treasury bills  federal agencies only for those services that it considers outside the basic  level of service negotiated with the designated commercial banks. In fiscal  year 2000, Treasury charged Education $26,353 for these ancillary services.  Specifically, this amount was charged for the cost of shipping reports and  other material by overnight mail to Education.
In February 1998, Education implemented EDA to allow FDLP borrowers  to have their loan payments automatically withdrawn from a bank account  each month. Then, in November 1999, Education began offering a 0.25- percentage point reduction in the interest rate to borrowers who agreed to  repay their loans this way. The number of borrowers who made their loan  payment through EDA went from 40,023 in October 1999, before the  discount went into effect, to 364,704 in September 2001.
The cost justification model Education developed used eight key  assumptions. These assumptions included such things as the interest rate  charged to borrowers, the number of outstanding loans, and two  assumptions concerning borrower behavior—estimates of how many  borrowers would likely enroll in the program once it was established and  the likelihood that borrowers would continue to prepay their loans after  enrollment. As the basis for developing these assumptions, Education  relied on a variety of factors, including prevailing Treasury interest rates,  private sector experiences with electronic debit repayments, conventions  economists generally use in the absence of data, and analysis of its student  loan portfolio. Table 1 shows the eight key assumptions used in  Education’s cost justification model and the basis of each assumption.
Borrowers have the right to prepay their loans. If a borrower repays any  amount in excess of the amount due, the excess amount is a prepayment.  Loan repayments, including prepayments, are credited first to any accrued  charges or collection costs and then to outstanding interest and principal.  Because prepayments generally reduce a borrower’s principal balance  outstanding, the amount of interest that accrues in subsequent months is  also reduced, decreasing the amount of interest the borrower pays over  the life of the loan. Borrowers who pay by check can easily make  repayments in excess of the amount due, for example, by rounding up  their repayment, but EDA borrowers have to take extra steps to prepay  because only the scheduled repayment amounts are withdrawn from EDA  borrowers’ accounts. In practice, the amount due without regard to the  0.25 percent discount is withdrawn. Therefore, EDA borrowers do not  receive a reduction in the amount they repay each month, but more of  each repayment is applied to the principal balance and they will repay  their loans faster as a result.
A variety of factors can affect a borrower’s decision about whether to  prepay a loan. Given that FDLP interest rates for direct loans cannot  exceed 8.25 percent and the interest paid is tax deductible for borrowers  who do not exceed certain income limits, prepaying may not be the best  option for all borrowers. For instance, borrowers who have recently  entered the workforce when they begin repaying their loans may not have  sufficient resources to prepay their loans. Rather than prepay their direct  student loans, some borrowers may also decide to instead repay any  higher-interest debt they have accumulated, for which interest paid is not  tax deductible, such as credit card debt.
section_title: While More than Twice as Many Borrowers Enrolled in EDA than Education Assumed, the Extent to Which They Have Continued to Prepay Their Loans Is Unknown
paragraphs: While more than twice as many borrowers have enrolled in the EDA  program than originally assumed, the percentage of EDA borrowers who  have continued to make prepayments remains unknown. In developing its  cost justification of the EDA program, Education assumed that a certain  percentage of borrowers would likely enroll in the program and that a  certain percentage of these borrowers would continue to prepay their  loans. Education based these assumptions on reported private sector  experiences with electronic debit repayments and on conventions  economists use in the absence of data. Education lacks data showing  borrowers’ prepayment patterns before and after enrolling in the program,  thus it cannot determine the extent to which its assumption has  materialized.
Education’s assumption that 5 percent of direct loan borrowers would  enroll in the EDA program was an estimate based on the experiences of  large, national private sector guaranteed loan lenders’ programs similar to  EDA. As of September 2001, the actual percentage of EDA enrollees is  closer to 12 percent, which, according to Education’s cost justification,  would increase the savings to the government to over $19 million. Table 2  shows government savings at the originally assumed 5 percent enrollment  rate and our estimates of the savings that Education’s cost justification  model would project if higher EDA enrollment rates were to materialize,  keeping the prepayment assumption constant.
Education also obtained information from private sector lenders on their  experiences with continued prepayment by borrowers after enrolling in  EDA-like programs. Private lenders reported mixed results. For example,  one lender reported that 20 percent of borrowers who previously prepaid  continued to prepay after enrolling in such a program while another lender  reported that 80 percent continued prepaying, according to Education  officials. Given the wide variance in reported experience, Education  officials concluded that they could not make an assumption based on  these data. Therefore, Education assumed a random distribution of  borrowers likely to continue to prepay, with 50 percent of those who had  prepaid continuing to do so and 50 percent discontinuing prepayment.
While we were able to determine the extent to which Education’s  assumption about EDA enrollment materialized, we were unable to  determine the extent to which its assumption for continued borrower  prepayment materialized. Limitations in Education’s Direct Loan Servicing  System prevented us from obtaining data on borrower history of  repayment activity. Education can identify borrowers who are paying their  loans ahead of schedule and, therefore, likely to be prepaying. However, it  cannot identify EDA participants from this data and it lacks trend data  showing how frequently and by how much borrowers prepay their loans.  Individual borrower payment activity data are available for only the most  recent 2 months. Given that borrowers change their prepayment patterns  at their convenience throughout their loan repayment period, these data  would not have covered a long enough time period to determine how  prepayment patterns have changed. Consequently, we could not compare  the overall patterns of borrowers’ prepayment behavior before or after  enrolling in the EDA program.
section_title: Education Has Not Informed Borrowers about the Possible Cost Implications of EDA Participation or Prepayment Options
paragraphs: Education has not informed borrowers of the possible cost implications of  EDA participation nor has it systematically informed borrowers of their  prepayment options. Education has not told borrowers that because  repayment through EDA may take longer, they may incur more interest  cost over the life of the loan than if they previously prepaid without EDA.  While Education has made some information available to borrowers online  about where to send supplemental repayments, it has not systematically  informed all borrowers of their prepayment options. Further, Education  has not updated its borrower publications to inform borrowers of the  option and benefits of repaying their loans through EDA.
subsections: section_title: Borrowers Are Not Informed about Cost Implications of EDA Participation
paragraphs: Education has not taken steps to inform EDA borrowers that—even with a  reduced interest rate—they could pay more interest over the life of the  loan. This could happen if prior to enrolling in EDA, they made  repayments that exceeded the scheduled amount due, but after enrolling  paid only the amount due. When borrowers establish an EDA, there is no  place on the application form to designate an amount in addition to the  scheduled payment to be withdrawn each month. To continue their  prepayments, such borrowers would have to send a check for any  prepayment or make arrangements to continue making prepayments  through EDA.
section_title: Borrowers Are Not Systematically Informed of Their Prepayment Options
paragraphs: The Higher Education Act of 1965, as amended, requires that student loan  borrowers be informed that they may prepay all or part of their loans at  any time without penalty, but it does not require the disclosure of specific  prepayment options. In documents such as the master promissory note  and borrower publications, Education informs borrowers that they may  prepay their loans. In May 2001, after we began our work, Education  added information to the direct loan servicing Web site indicating where  EDA borrowers wishing to prepay their loans could send supplemental  payments. While this information may help borrowers with Internet  access, Education has not disclosed this information in EDA brochures,  the EDA application, or the confirmation notice sent to borrowers who  establish EDAs. Further, Education does not inform EDA borrowers that  they may make routine prepayments, by contacting the direct loan servicer  at any time and increasing the amount withdrawn from their bank account  each month.
In addition to not disclosing prepayment options, Education had not  updated two of its borrower publications to fully reflect the option  borrowers have to repay through EDA. One publication, Exit Counseling  Guide for Borrowers, does not provide details about how EDA works, the  advantages of EDA for making loan payments, or the reduced interest rate  EDA borrowers receive. The other publication, Repayment Book, which is  available to help borrowers understand and select from the available  repayment plans, makes no reference to EDA.
section_title: Use of EDAs Generated Estimated Administrative Cost Savings of More than $2.7 Million in Fiscal Year 2001 for Education and Treasury
paragraphs: Education and Treasury achieved administrative cost savings because  EDAs reduced the costs associated with billing and processing payments.  Education saved an estimated $1.5 million in fiscal year 2001 as a result of  generating and mailing fewer bills to EDA borrowers. Additional savings  are also possible with respect to costs associated with servicing past due  accounts. Treasury, which processes direct loan payments and incurs  most of the associated processing costs, saved an estimated $1.2 million in  fiscal year 2001.
subsections: section_title: Education Saved on Administrative Costs by Not Sending Monthly Billing Statements to EDA Borrowers
paragraphs: As a result of EDA, Education reduces administrative costs associated  with generating and mailing billing statements to borrowers. According to  our review of Education cost data, in fiscal year 2001, Education saved  about $1.5 million or $0.39 per month for each borrower who used EDA.  This savings includes the cost of things such as the paper billing  statement, the mailing envelope, and postage. Through EDA, Education  avoided sending out more than 3.6 million billing statements over the  course of fiscal year 2001. The other administrative costs Education incurs  for servicing direct loan accounts are the same for all borrowers,  regardless of their payment method. Table 3 shows the specific costs  Education incurs for routine servicing of FDLP accounts. EDA should  result in additional administrative cost savings by reducing the potential  for late payments and accompanying collection efforts, according to an  Education official.
Some of the administrative savings Education achieves with EDA are  offset with expenses that Education incurs at Treasury. Education pays  Treasury for processing EDA applications. In fiscal year 2000, Treasury  charged Education about $128,900 for processing 253,000 EDA  applications.
In the course of doing our work, we identified a potential opportunity for  additional administrative cost savings unrelated to EDA. Education  adheres to a price structure for servicing delinquent accounts that may not  be appropriate. Currently, the direct loan servicer assesses Education a  separate fee for each day a borrower’s account is at least 1 day past due.  This fee applies to all late direct loan payments, but because EDA  payments are credited on the due date—provided sufficient funds are  available in the borrower’s bank account—this fee would generally not  apply to EDA borrowers. The late fee Education is assessed for past due  accounts covers additional work the direct loan servicer performs, such as  sending second billing statements to borrowers, and making reminder  phone calls. These collection activities occur at regularly scheduled  intervals as part of Education’s default prevention initiatives.
As previously stated, Education is assessed a fee for each day a borrower’s  account is at least 1 day past due. Education officials stated that this  contract provision has been in place since FDLP implementation. In the  past, the direct loan servicer sent late payment notices to borrowers as  soon as payments were one day late. However, according to Education  officials, borrowers who had already mailed their payments found these  notices confusing. As a result, Education decided to delay late payment  notification to allow additional time to receive those payments made by  borrowers close to or on the due date. Presently, the direct loan servicer’s  first collection activity—sending a second billing statement—does not  take place until a payment is 7 days late. However, Education is still  assessed fees on payments that arrive 1 to 6 days late. In fiscal year 2001,  Education paid $12.2 million or about $0.05 per day for each account that  was at least 1 day past due. Because of limitations of data in the DLSS,  Education is unable to determine the extent to which it is paying this fee  each month for payments received between 1 and 6 days late.
section_title: Treasury Achieved Savings by Processing Loan Payments Electronically
paragraphs: In fiscal year 2001, we estimate Treasury, which has an interagency  agreement with Education to process direct loan payments, saved about  $1.2 million as a result of EDA. These savings are based on the dollar  volume of payments received. Treasury estimates that processing  payments electronically costs less than 1 percent of the cost of processing  paper payments. For example, it costs about $16 to process $1 million  through EDA; processing the same amount in paper payments costs about  $1,897. According to officials from Treasury’s Financial Management  Service, Treasury processes payments for federal agencies to ensure  efficient and timely processing of payments, and because Treasury can  achieve economies of scale by providing this service throughout the  federal government.
section_title: Conclusions
paragraphs: Regardless of the conclusions Education reached in its cost justification,  borrowers who enroll in EDA will benefit from paying a reduced interest  rate on their loans and the federal government will achieve administrative  cost savings. Data limitations make it difficult to assess whether  borrowers have changed their prepayment behavior as Education assumed  in its cost justification, and thus, the extent of the benefit for both  borrowers and the federal government is unknown. Even if data were  available and showed borrowers’ had changed their behavior, it would not  tell us that this behavior changed as a result of entering EDA. Rather,  borrowers could be making sound economic decisions such as choosing to  prepay a higher rate loan rather then their federal student loan. By fully  informing borrowers of the consequences of paying through EDA as well  as their prepayment options, Education could ensure that borrowers have  all the information they need to make sound economic choices. However,  the limited disclosures Education currently makes to borrowers  concerning their prepayment options under EDA are not sufficient to  ensure that borrowers have all essential information to make informed  decisions. Education does not make clear that, in spite of the 0.25  percentage-point interest rate reduction, borrowers might incur more  interest cost over the life of their loans under EDA than they would if they  continued to sometimes make payments in excess of the scheduled  amount due.
Although Education did not include estimated administrative cost savings  associated with EDA in conducting its cost justification, clearly, these  savings would help offset the expense of offering borrowers a reduced  interest rate. EDA can further reduce administrative costs associated with  loan processing if more borrowers use it. Education has not promoted the  benefits of EDA to borrowers as much as possible to maximize  administrative cost savings to the federal government. Promoting the  benefits of EDA to borrowers when they are considering their repayment  options could achieve even greater administrative cost savings if more  borrowers were to participate in EDA as a result. Moreover, EDAs should  reduce the amount of higher fees that Education incurs for servicing past  due accounts, because EDA payments are generally credited on time.
Although not related to EDA, Education may be able to achieve additional  administrative cost savings. At present, Education is paying a fee for  servicing EDA and non-EDA accounts that are at least 1 day past due. We  believe that those fees may be unjustified because no action is taken to  collect late payments until they are 7 days past due.
section_title: Recommendations
paragraphs: To help make the EDA program more useful and understandable to  borrowers and take greater advantage of its potential savings to the  taxpayer, we are making several recommendations to the secretary of  education.
To better publicize EDA and help Education achieve additional  administrative cost savings, we recommend updating the Exit Counseling  Guide for Borrowers to reflect the repayment incentives for direct loan  borrowers who repay their loans through EDA as well as borrowers’  prepayment options.
To address concerns that borrowers may unknowingly pay more total  interest over the life of their loans by not making prepayments if they  make their loan payments through EDA, we recommend Education take  steps to inform EDA borrowers about steps they can take to prepay their  loans. Such steps could include modifying EDA applications to allow  borrowers interested in prepaying their loans to designate withdrawal  amounts in excess of their scheduled payments when they initially  complete the EDA application.
To ensure that the fees Education pays for servicing delinquent accounts  appropriately reflect current collection activity practices, we recommend  Education consider renegotiating the fee provision in its contract with the  direct loan servicer to eliminate the servicing fee for accounts with  payments less than 7 days late.
section_title: Agency Comments
paragraphs: In comments we obtained, Education generally agreed with the  information presented in the report.  In response to our recommendation,  Education said that it would explore updating the Exit Counseling Guide  for Borrowers and explore taking other steps to better inform borrowers  of their prepayment options.  In addition, Education said it would  consider renegotiating the direct loan servicing contract to move in the  direction of paying for results rather than processes.  Education also  provided technical comments, which we incorporated where appropriate.
We are sending copies to the secretary of education, the secretary of the  treasury, and the director of the Office of Management and Budget and  will also make copies available to others on request. This report is also  available on GAO’s home page at http://www.gao.gov.
If you or your staff have any questions or wish to discuss this material  further, please call me at (202) 512-8403 or Jeff Appel at (202) 512-9915.  Other staff who made key contributions to this report include Barbara  Alsip, Joel Marus, Scott McNabb, and Debra Prescott.