Federal Student Loans: Borrower Interest Rates Cannot Be Set in Advance to Precisely and Consistently Balance Federal Revenues and Costs
Published: 2014-01-31T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Federal student loans issued under the Direct Loan program play a key role in ensuring access to higher education for millions of students. The costs of the program to the government include administrative costs like loan servicing. They also include subsidy costs, which are the estimated long-term costs to the government of providing loans, such as the government’s cost of borrowing and defaults on loans. Some have questioned whether borrower interest rates can be more precisely set to cover these costs without generating excess federal income. The Bipartisan Student Loan Certainty Act of 2013 required GAO to provide information on issues related to the cost of federal student loans.
This report addresses (1) how the costs of administering the Direct Loan program have varied in recent years, (2) how estimated subsidy costs have varied in recent years, and (3) how changes in different variables influence the overall cost of the program and the borrower interest rate needed to cover those costs.
GAO reviewed Direct Loan administrative cost data and analyzed subsidy cost data from Education for fiscal years 2007 through 2012, which are presented in nominal dollars throughout the report. In addition, GAO worked with Education to illustrate how changes in variables such as government borrowing costs could affect Direct Loan subsidy costs. GAO also examined whether borrower rates could be set so the government could cover Direct Loan costs without generating excess revenue (known as a breakeven analysis). GAO reviewed relevant federal laws, guidance, and reports; and interviewed Education and other agency officials.
GAO does not make recommendations in this report. The Department of Education agreed with our findings.
section_title: What GAO Found
paragraphs: Total Direct Loan administrative costs grew from $314 million to $864 million from fiscal years 2007 to 2012, but federal costs per borrower have generally remained steady or fallen. The increase in total administrative costs largely results from an increase of over 300 percent in the number of Direct Loans during that same time period. One key factor contributing to this loan volume increase was a law that ended student loan originations under a federally guaranteed loan program resulting in new originations being made under the Direct Loan program. Loan servicing--which includes activities like counseling borrowers on selecting repayment plans, processing payments, and collecting on loans in delinquent status--is the largest category of administrative costs, comprising 63 percent of total Direct Loan administrative costs in fiscal year 2012. While total administrative costs have increased, costs per borrower and other unit costs have remained steady or declined. For example, the servicing cost per borrower has remained roughly $25 over the six-year period we examined. However, a number of factors, including a new payment structure for loan servicing contracts to reward servicers for keeping more borrowers in repayment status, have created some uncertainty about the servicing cost per borrower in coming years.
Separate from administrative costs, estimated subsidy costs vary by loan cohort--a group of loans made in a single fiscal year--and change over time. Based on the Department of Education's (Education) recent estimates, the government would generate subsidy income for the 2007 to 2012 Direct Loan cohorts as a group. However, estimates will change, because current subsidy cost estimates for these cohorts are based predominantly on assumptions about future revenue and costs. Actual subsidy costs will not be known until all cash flows have been recorded, generally after loans have been repaid. This may be as many as 40 years from when the loans were originally disbursed, because many borrowers do not begin repayment until after leaving school, and some face economic hardships that extend their payment periods. Subsidy cost estimates fluctuate over time due to the incorporation of updated data on actual loan performance and the government's cost of borrowing, as well as revised assumptions about future revenue and costs, through the annual reestimate process. As a result, there can be wide variations in the estimated subsidy costs for a given cohort over time. For example, the 2008 loan cohort was estimated to generate $9.09 of subsidy income per $100 of loan disbursements in one year, but in the next year that same cohort had an estimated subsidy cost of 24 cents per $100 of loan disbursements, a swing of $9.33. Volatility in subsidy cost estimates for a given cohort is generally expected to decrease over time as more actual loan performance data become available.
Because Direct Loan costs fluctuate with changes in certain variables, borrower interest rates cannot be set in advance to balance government revenue with costs consistently over the life of the loans. In a simulation of how loan costs respond to changes in selected variables, the costs were highly sensitive to changes in the government's cost of borrowing. This, coupled with cost estimates regularly updated to reflect loan performance data, means the total costs associated with Direct Loans are in flux until updates are recorded through the end of the loans' life cycle, which takes several decades. Therefore, the borrower interest rates that would generate revenue to exactly cover total loan costs—known as breaking even—would change over time. To determine whether or not a set of conditions that would break even for one cohort would also break even for another cohort under different circumstances, GAO used data forecasted for future years to experiment with certain aspects of the borrower interest rate for two separate cohort years.
• GAO selected cohort years 2014 and 2019 because economic conditions may be different several years apart.
• For these cohorts, the following three aspects of the borrower interest rate were altered: the index (the base market rate to which student loan interest rates are pegged), the mark-up rate (the percentage-point increase over the base rate that students are charged), and the differences in the mark-up rates among loan types, including undergraduate, graduate student, and parent loans.
• GAO looked at how these changes to the borrower rates would affect total government costs, taking into account both administrative and subsidy costs.
• Changing the index and mark-up rates helped achieve a breakeven point based on current cost estimates for the 2014 cohort; however, cost estimates for this cohort will change as updated data become available over the life of the loans.
• When GAO applied the same index and mark-up rates that temporarily resulted in a breakeven point for the 2014 cohort to the 2019 cohort, it resulted in a net cost to the government.
• The difference in outcome for these two cohorts is because Direct Loan costs are sensitive to variables, such as government borrowing costs, that are projected to look very different for 2019 than they did for 2014.
• As illustrated in the simulation, the borrower interest rates that are needed to cover costs at one point in time may not be effective at another point in time and cannot be precisely determined in advance to enable the government to break even consistently.
Available information on Direct Loan costs illustrates the difficulties of accurately predicting what these program costs will be, and how much borrowers should ultimately be charged to achieve a particular outcome. Specifically, fluctuations in the actual and expected costs of the student loan program over time make it challenging to target a particular borrower interest rate that would consistently break even. Making frequent changes to the borrower interest rate could help program costs more closely match revenues in the short term, but it could confuse potential borrowers and complicate efforts to make the program transparent to students.

section_title: Letter
paragraphs: Federal student loans play a key role in ensuring access to  postsecondary education for millions of students each year. In the 2012- 2013 award year, the U.S. Department of Education (Education) reported  disbursing more than $94 billion in student loans to nearly 17 million  student borrowers and their parents under the William D. Ford Federal  Direct Loan (Direct Loan) Program. In recent years, the interest rates  that borrowers paid on these loans were set at levels fixed through  statute. However, interest rates on certain Direct Loans were set to  double in July of 2013, contributing to concerns about the burden of rising  student loan debt on borrowers. In response, Congress enacted the  Bipartisan Student Loan Certainty Act of 2013, which tied borrower  interest rates on Direct Loans issued on or after July 1 to the interest rate  on the 10-year Treasury note. Borrower interest rates are now equal to  the 10-year Treasury note rate plus a mark-up that depends on the  borrower and loan type. There are also caps on borrower interest rates,  which protect borrowers when interest rates are high. However, questions  remain about how much students and their parents should be charged to  borrow money from the government to finance students’ education. Some  policy makers and higher education experts maintain that the interest rate  charged to borrowers should cover—but not exceed—federal program  costs, which comprise administrative and subsidy costs. Administrative  costs include costs such as processing loan applications and servicing  existing loans. Subsidy costs represent the estimated long-term cost of  extending credit over the life of a loan, excluding administrative costs. A  clear understanding of both administrative costs and subsidy costs is  necessary to understand the implications of setting borrower interest  rates to achieve particular policy goals.
The Bipartisan Student Loan Certainty Act of 2013 required that GAO  examine a variety of issues related to the cost of federal student loans to  the federal government. administering the Direct Loan program have varied in recent years, (2)  how estimated subsidy costs associated with the Direct Loan program  have varied in recent years, and (3) how changes in different variables  influence the overall cost of the Direct Loan program and the borrower  interest rate needed to cover those costs.
Pub. L. No. 113-28, § 4, 127 Stat. 506, 507. We focus on Direct Loans in this report  because they represent the large majority of federal student loans currently issued by  Education. calculate certain administrative costs for all loan programs, and do not  track Direct Loan costs separately because doing so has not been  necessary for management purposes. As Direct Loan administrative  appropriations make up the large majority of funds appropriated to  Education’s administrative account, we determined that these data were  sufficient to illustrate Direct Loan administrative cost trends. For our  second research question, we analyzed data from Education subsidy cost  estimates and reestimates for the 2007-2012 Direct Loan cohorts, in  order to understand trends in cost estimates. For our third research  question, we worked with Education officials to alter key variables in the  agency’s subsidy cost estimate to illustrate how changes in certain  variables, such as risk of default, could affect the overall cost of the Direct  Loan program. We used reported data from fiscal years 2007 through  2012 to illustrate a range of possible government costs. See appendix I  for more detail on these analyses. Throughout the report, cost figures are  reported in nominal dollars. In addition to our various analyses, we  interviewed officials at Education and the Congressional Budget Office  (CBO) regarding key issues related to Direct Loan administrative and  subsidy costs. We also reviewed relevant federal laws and guidance, as  well as past GAO reports for the purposes of all of our research  questions.
We conducted this performance audit from August 2013 to January 2014  in accordance with generally accepted government auditing standards.  Those standards require that we plan and perform the audit to obtain  sufficient, appropriate evidence to provide a reasonable basis for our  findings and conclusions based on our audit objectives. We believe that  the evidence obtained provides a reasonable basis for our findings and  conclusions based on our audit objectives.
subsections: section_title: Background
paragraphs: Under the Direct Loan program, Education issues three main types of  loans—Subsidized Stafford, Unsubsidized Stafford, and PLUS Loans.
Subsidized Stafford Loans are available only to undergraduate student  borrowers with demonstrated financial need. The government subsidizes  these loans by not charging borrowers for the interest that accrues while  they are still in school and during a 6-month grace period after leaving  school. Unsubsidized Stafford Loans are available to both undergraduate  and graduate student borrowers, irrespective of financial need. Borrowers  are responsible for paying all interest from disbursement to final payoff of  the loan. Finally, PLUS Loans are available to graduate students and  parents of dependent undergraduates, who must pay all interest on these  loans as well.
Borrower Rate: The interest rate   charged to federal student loan recipients. rates and caps vary by loan type and borrower characteristics, as seen in  table 1 below. Undergraduate student borrowers pay the lowest interest  rate, with graduate student and parent borrowers paying somewhat  higher rates.
There are a variety of repayment plan options available to eligible student  loan borrowers. Under the standard repayment plan, borrowers typically  repay loans over a period of up to 10 years. Key features of other plans  are extended repayment periods and repayment amounts that are linked  to borrowers’ income. For instance, under the income-contingent  repayment plan, repayment amounts are calculated annually based on  the borrower’s adjusted gross income, family size, and total Direct Loan  amount. Repayment periods under these plans may be up to 25 years. By  extending their repayment periods, borrowers may lower their monthly  payments, but may pay more in interest over time.
subsections: section_title: Types of Direct Loan Costs
paragraphs: The Direct Loan program has two main categories of costs: administrative  costs and subsidy costs. See table 2 below for selected elements of these  two types of costs. Some subsidy elements (like government borrowing  costs) raise subsidy costs, while others (like borrower principal  repayments) lower them.
The funding for Direct Loan administration is generally discretionary,  meaning that Congress periodically appropriates the level of funding it  deems appropriate. The funding for subsidy costs, on the other hand, is  mandatory, meaning that funds are not appropriated annually. Instead,  Congress has enacted permanent statutory authority to appropriate  funding for loans to eligible borrowers.
section_title: Direct Loan Administrative Costs
paragraphs: The majority of the Direct Loan program’s administrative costs are funded  by discretionary appropriations to Education’s Student Aid Administration  account. The Student Aid Administration account provides funds to  administer the Direct Loan program as well as other federal student aid  programs including the Federal Family Education Loan Program.  Administrative costs support activities such as educating students and  families about how to obtain loans; processing loan applications;  disbursing loans; administering existing guaranteed loans; servicing loan  accounts; and taking action to prevent fraud, waste, and abuse. Costs to  manage and collect payments on defaulted loans are also included in  administrative costs.
Administrative Costs: Loan program  expenses that are excluded from subsidy cost  calculations, such as costs related to  processing loan applications or servicing  existing loans.
Education uses an activity-based costing model that tracks administrative  cost by processes, such as application processing or loan servicing. In  the model, Education calculates the full administrative cost of each  process by first identifying its direct costs (or costs that can be tied to that  specific process) and then allocating additional indirect costs, such as  rent, equipment, and maintenance, to each process based on formulas  intended to reflect how many indirect resources each process uses. Costs  that include direct and indirect costs are called full costs. Education uses  both full and direct costs to generate costs per unit, such as cost per  application processed or borrower serviced.
section_title: Direct Loan Subsidy Costs
paragraphs: As required by the Federal Credit Reform Act of 1990 (FCRA), Education  estimates loan subsidy costs annually for inclusion in the President’s  budget. For Direct Loans, subsidy costs represent the estimated long- term cost to the government of extending credit over the life of the loan,  excluding administration costs. Subsidy cost estimates that are recorded  in a given year are calculated based on the net present value of lifetime  estimated cash flows to and from the government that result from  providing these loans to borrowers. For Direct Loans, cash flows from  the government include loan disbursements and cash flows to the  government include repayments of loan principal, interest and fee  payments, and recoveries on defaulted loans.
The Federal Credit Reform Act of 1990 (FCRA) was intended to improve the  measurement of the budgetary costs of federal credit programs. Prior to the  implementation of FCRA, credit programs were reported in the budget on a cash basis.  Thus, loan guarantees appeared to be free in the budget year of the guarantee, while  direct loans appeared to be as costly as grants. As a result, costs were distorted and  credit programs could not be compared meaningfully with other non-credit programs and  with each other. FCRA recognized that the true cost of a loan or guarantee is not captured  by its cash flows in any one year, but by the net value of its cash flows over the life of the  loan. This value is known as the “subsidy cost”—that is, the estimated long-term cost to  the government of a direct loan or loan guarantee, calculated in current dollars, excluding  administrative costs. Administrative costs remain on a cash basis and are excluded from  subsidy calculations.
Subsidy costs are influenced by a variety of variables, including  government borrowing costs, the interest rate charged to student loan  recipients, how quickly those recipients repay their loans, and how many  ultimately default. A positive subsidy cost estimate indicates that the  government anticipates a net cost, while a negative subsidy cost estimate  indicates that the government anticipates generating net subsidy income,  not counting administrative costs. To determine the overall cost of the  Direct Loan program, both subsidy and administrative costs must be  considered. For the government to break even on Direct Loans, net  subsidy income should be equal to administrative costs.
Subsidy Cost: The estimated long-term cost  to the government of providing a loan,  expressed in current dollars, and excluding  administrative costs.
Education calculates subsidy costs separately for each group of loans  made in a particular fiscal year—referred to as a loan cohort. To estimate  subsidy costs, Education has developed a Student Loan Model that  contains a variety of assumptions. These assumptions are reflected  through variables such as how quickly borrowers will repay their loans  (and, thus, how much interest the government will collect), how many  borrowers will default, and how successful default collection activities will  be.
Education annually reestimates subsidy costs for each loan cohort until all  loans in the cohort have been repaid, which may take decades.  Reestimates take into account actual loan performance as well as  changes in assumptions about future performance, such as how many  borrowers will default, or how many will participate in extended repayment  plans. Reestimates may result in increases or decreases in subsidy cost  estimates.
Loan Cohort: A group of loans made in a  particular fiscal year.
In addition to Education’s subsidy cost estimates, CBO also estimates  subsidy costs to identify the financial impact of legislation and inform  budget projections, among other purposes. CBO and Education both  estimate subsidy costs for the Direct Loan program following the  requirements of FCRA; however, they use different estimation  methodologies and assumptions. Officials from both organizations  pointed to a number of key areas where their assumptions differed. See  table 3 for examples of key differences. Officials cited a number of  reasons for differences in these particular assumptions, including  differences in economic forecasts and professional judgment when  developing forecasting methodologies. Because of such differences, CBO  and Education’s cost estimates for the program are not comparable.
section_title: Total Direct Loan Administrative Costs Grew from $314 Million to $864 Million in Recent Years, but Costs per Borrower Have Generally Remained Steady or Fallen
subsections: section_title: Total Direct Loan Administrative Costs Grew by $550 Million from Fiscal Years 2007 to 2012, Largely Driven by an Increase in the Number of Direct Loans
paragraphs: The Department of Education reported that full administrative costs (i.e.  costs incorporating both direct and indirect administrative costs) for the  Direct Loan program increased by $550 million from fiscal year 2007 to  fiscal year 2012, to total $864 million in fiscal year 2012. These Direct  Loan administrative costs represent 65 percent of the $1.3 billion in new  budget authority made available to the Student Aid Administration  account in fiscal year 2012, while administrative costs for other loan,  grant, and loan guarantee programs and activities made up the   Loan servicing, which includes activities related to  remainder.processing loan payments and maintaining borrower information, is the  largest category of reported administrative costs, comprising 63 percent  of total administrative costs in fiscal year 2012. Figure 1 below shows  total Direct Loan Program costs by category from fiscal year 2007 to fiscal  year 2012.
Total Direct Loan administrative costs reported by the Department of  Education rose from $314 million to $864 million—a 175 percent  increase—from fiscal year 2007 to fiscal year 2012. Loan servicing costs  showed the greatest dollar increase at over $300 million (152 percent)  during that time period. Although other categories—application  processing, school oversight and monitoring, and originations and  disbursements—showed smaller dollar increases, the percentage growth  of these categories ranged from about 270 percent to about 440 percent.
Only default collections, including the management and collection of  defaulted loans and assistance to defaulted borrowers, stayed generally  flat in total dollars.
Education officials stated that total administrative costs are largely driven  by loan volume and the number of borrowers and, therefore, costs have  increased as the number of Direct Loans has increased. The reported  number of outstanding Direct Loans increased over 300 percent, from 19  million to over 88 million, from fiscal year 2007 through fiscal year 2012.  As shown in figure 2 below, the largest loan volume increases were in  Subsidized and Unsubsidized Stafford loans.
Several factors contributed to the increase in the number of Direct Loans.  For example, beginning in 2008, changes in the student loan market led  numerous schools to transition from the Federal Family Education Loan  program to the Direct Loan program.Fiscal Responsibility Act terminated the authority to make or insure new  loans under the Federal Family Education Loan program after June 30,  2010, with subsequent federal student loans originated under the Direct  Loan program. Education officials also stated that the economic downturn  in 2008 coincided with an increase in student loan volume as individuals  returned to school.
section_title: Costs per Borrower and Other Unit Costs Have Generally Remained Stable or Fallen
paragraphs: While total reported administrative costs increased from fiscal year 2007  to fiscal year 2012, cost per borrower and other unit cost measures  remained stable or fell. Unit costs are a measure Education uses to track  costs such as cost per loan origination, cost per borrower serviced, and  cost per application processed. See table 4 for a description of these  unit cost measures. According to Education officials, increased loan  volume resulted in a decrease in many unit costs. For example, total loan  servicing costs for all programs supported by the Student Aid  Administration account increased from fiscal year 2007 to fiscal year  2012; however, the number of borrowers serviced for these programs  also increased from 9.7 million in fiscal year 2008 to 29.7 million in fiscal  2012. As a result, the annual servicing cost per borrower decreased  slightly during that time, remaining at roughly $25 per borrower. While the  overall flat or downward trend persisted over most of the years we  studied, Education reported a slight increase in unit costs from fiscal year  2011 to 2012, attributable to such changes as lower volumes of  applications and originations.
Recent changes in loan servicing contracts, combined with other factors,  have increased uncertainty about what servicing costs per borrower will  be in coming years. Prior to 2009, all loans were serviced under a single  contract, referred to as the Common Services for Borrowers (CSB)  contract. Under the CSB contract, Education paid servicers based on loan  volume, paying a smaller fee per borrower as the number of borrowers  serviced increased. In order to accommodate increasing loan volume,  Education began to contract with additional loan servicers in 2009. The  new contracts use a different pricing structure to encourage servicers to  keep more borrowers in a repayment status. For example, under one  such contract, the servicers receive the highest rate for borrowers who  are in-grace, in current repayment, or delinquent for 30 days or less, and  the lowest rate for borrowers who have been delinquent for 270 days or  more. Education officials stated that under the new contracts, they may  pay more per borrower but may also keep more borrowers in  repayment. Education also recently reported that the large portfolio of  Direct Loans originated after the move away from the Federal Family  Education Loan Program is in the process of maturing from the cheaper  “in-school” servicing cost status to the more expensive “in-repayment”  servicing cost status. As a result of these changing circumstances—a  new servicing payment structure, new servicers collectively managing an  increasing volume of loans, and the maturing of the Direct Loan  portfolio—whether future servicing costs per borrower will increase or  decrease is uncertain, according to Education officials.
section_title: Estimated Subsidy Costs Differ across Loan Cohorts and Fluctuate over Time
subsections: section_title: Subsidy Costs Vary by Loan Cohort, and Current Estimates Show the Government is Expected to Generate Subsidy Income from Recent Cohorts
paragraphs: Reestimate: Annual recalculation of estimated  lifetime loan subsidy costs for each cohort,  incorporating updated information on actual loan  performance and revised assumptions about  future cash flows.
As of the end of fiscal year 2013, it is estimated that the government will  generate about $66 billion in subsidy income from the 2007 to 2012 loan  cohorts as a group.  However, current estimates for this group of loan  cohorts are based predominantly on forecasted cash flow data derived  from assumptions about future loan performance.on actual cash flows for these loans becomes available, subsidy cost  estimates will change. As a result, it is unclear whether these loan cohorts  will ultimately generate subsidy income, as currently estimated, or  whether they will result in subsidy costs to the government. This will not  be known with certainty until all cash flows have been recorded after   As more information  loans have been repaid or discharged—which may be as many as 40  years from when the loans were originally disbursed.
As seen in figure 3 below, overall subsidy rates—subsidy costs as a  percentage of loan disbursements—are generally estimated to decrease  across the 2007 to 2012 loan cohorts. Moreover, later loan cohorts in this  range are estimated to generate more subsidy income than the earlier  loan cohorts, as indicated by the increasingly negative subsidy rates.Our analysis of how the various components of subsidy costs differ  across cohorts shows that, relative to the financing costs, the defaults,  fees, and all other costs of the subsidy rate were relatively stable across  the 2007 to 2012 loan cohorts. For example, these costs were estimated  to vary between 1 to 2.4 percentage points across cohorts, while the  financing costs were estimated to vary almost 19 percentage points  across cohorts.
As seen in figure 3, the financing component of the subsidy cost is  estimated to generally decrease across cohorts. Financing costs are  related to the interest payments borrowers make on Direct Loans and the  government’s cost of borrowing to finance its lending. Past GAO work has  found that the difference, or “spread,” between the borrower interest rate  and government’s cost of borrowing was a key factor in determining  whether there is a positive or negative subsidy for Direct Loans. As the  spread increases, so does the difference between the interest payments  Education receives from borrowers and the interest payments Education  makes to Treasury.
The spread between the borrower interest rate and the government’s cost  of borrowing varies by loan type, because different borrower rates are  established by law for subsidized Stafford, unsubsidized Stafford, and  PLUS loans. Figure 4 compares borrowers’ rates for the various Direct  Loan types, including the average borrower rate weighted by loan type (or  “weighted average”), with the government cost of borrowing. Specifically,  as seen in figure 4, Direct Loan borrower rates decreased for subsidized  Stafford loans as a result of statutory changes made during this time  period.
The spread between the government’s cost of borrowing and the  weighted average borrower rate (across all Direct Loan types) increased  between 2007 and 2009, when it peaked. During this time, the  government’s cost of borrowing fell more sharply than borrower interest  rates. In instances where the borrower rate is greater than the  government borrowing costs, as is the case between 2007 and 2012,  Education would be expected to receive more in interest payments from  borrowers than what it pays in interest to Treasury, increasing the  likelihood that revenues will exceed costs for the loan.
section_title: Subsidy Cost Estimates Fluctuate over Time Due to Regularly-Updated Data
paragraphs: Education’s estimates of lifetime loan subsidy costs have varied over time  based on updated information recognized during the reestimate process.  Through the reestimate process, subsidy cost estimates are updated for  each loan cohort to account for information on actual loan performance  and the government’s cost of borrowing.2012 have experienced both downward and upward adjustments to the  estimated subsidy costs over time due to these reestimates. Each year,  the estimated lifetime subsidy cost for a cohort will change to reflect the  most recent reestimate information. See textbox for more information on  the reestimate process.
Reestimate Process   Reestimates reflect changes related to both interest rate assumptions and non-interest rate  assumptions as actual cash flows are recorded after loans are disbursed.  For example, reestimates  show the difference between the estimated government borrowing costs (discount rate) when the  original subsidy rate is calculated, and the final government borrowing costs that are determined  when a loan cohort is substantially disbursed.
OMB guidance states that government borrowing costs are updated through reestimates  when a cohort is at least 90 percent disbursed. Because of the timing of disbursement for  Direct Loans, two different fiscal years of interest rate data feed into the final government  borrowing costs used for the reestimates. For example, actual data on the final government  borrowing costs for the 2007 loan cohort would be available in fiscal year 2009.
Once the government borrowing costs have been determined, the rate is set for the life of  the cohort.
Reestimates also reflect differences in actual versus estimated loan performance. For example, when  data get updated on the number of loans that were cancelled due to death, the information is included  in technical reestimates. The effects of changes in this variable on the overall cost estimate vary  depending on how the mortality rate changes from year to year. Changes in other variables such as  default rates and borrower participation in loan repayment plans also affect assumptions used for cost  estimates.
As shown in figure 5, there can be wide variations in the reestimated  subsidy rates and, consequently, the estimated subsidy costs, for the  same cohort over time. For example, the 2008 loan cohort was estimated  to generate as much as $9.09 in subsidy income per $100 of loan  disbursements based on the reestimate information published in the fiscal  year 2011 President’s budget. However, in the estimates published in the  fiscal year 2012 President’s budget, the same loan cohort was expected  to generate a small cost of 24 cents per $100 dollars of loan  disbursements, based on updated information. This represents a swing of  $9.33 per $100 of loan disbursements. Similarly, the original subsidy rate  estimate for the 2009 loan cohort indicated that the government would  generate a subsidy income of almost $15 per $100 of loan  disbursements. However, the revised estimate published in the fiscal year  2011 President’s budget indicated that the subsidy income the  government was expected to generate dropped by about 74 percent, to  $4 per $100 of loan disbursements. Figure 5 shows the original subsidy  rate and subsequent reestimated subsidy rates for the 2007 to 2012 loan  cohorts over time.
Volatility in subsidy cost estimates for a given cohort is generally  expected to decrease over time. An Education official explained that  estimates for loan cohorts experience more volatility in early reestimates  because less actual data, as opposed to forecasted data, are available to  inform the estimates. As more actual data become available for a cohort,  Education expects to see smaller changes in the reestimates over time.  For example:
Earlier cohorts with more actual data to inform the reestimate have  become less volatile: The estimates for the 2007 and 2008 cohorts  initially showed large downward adjustments in the reestimated  subsidy rates. In general, these cohorts currently are estimated to  have a subsidy rate close to zero, and the reestimated subsidy rates  have not varied much in the most recent reestimate years.
Later cohorts with less actual data to inform the reestimate are  currently more volatile: The 2009 through 2011 cohorts exhibit the  most volatility over the years for which reestimates are available, in  that recent reestimated subsidy rates for these cohorts have exhibited  larger changes than the 2007 and 2008 cohorts.
section_title: Because Direct Loan Costs Are Sensitive to Certain Variables, Borrower Interest Rates Cannot Be Set in Advance to Consistently Balance Government Revenue with Costs
subsections: section_title: Direct Loan Costs Are More Sensitive to Changes in Government Borrowing Costs than to Other Selected Variables
paragraphs: Direct Loan costs fluctuate according to changes in certain variables, with  varying levels of sensitivity. In particular, Direct Loan costs are sensitive  to changes in the government’s cost of borrowing, which changes for  each cohort of loans depending on economic conditions and the  characteristics of the cohort.information on loan performance that results in fluctuations in the cost  estimates themselves, means that total Direct Loan costs cannot be  known with certainty until actual data are available at the end of the loans’  life cycle—a process which takes decades. To illustrate this, we  conducted analyses that provide practical examples of how costs change  in response to certain variables.
Specifically, we tested the discount rate, which represents the cost of Education  borrowing funds from Treasury to finance the Direct Loan program. loans that Education considers to be at high risk of default. We tested  these variables under favorable and less-favorable conditions, from the  perspective of government costs. Specifically, favorable conditions  would likely reduce government costs, while less favorable conditions  would increase costs to the government. By comparing the percent  change in costs to the percent change in the variable, we determined how  sensitive the costs were to each variable. We refer to this ratio as the  sensitivity factor (see table 6). In the table, the sensitivity factor shows the  percent change in costs that would be associated with a one-percent  change in the indicated variable.
Of the variables we selected, Direct Loan costs were most sensitive to  changes in the government’s cost of borrowing in both the favorable and  less favorable scenarios, as shown by the sensitivity factors in table 6.  For example, in the favorable scenario, a 1 percent increase in the  government’s cost of borrowing was associated with a 19.7 percent  increase in subsidy costs. In contrast, costs were less sensitive to the  loan risk category, percentage of subsidized Stafford loans, and  percentage of income-contingent repayment plans in both the favorable  and less-favorable cases. For example, in the favorable scenario, a 1  percent decrease in income-contingent loans was associated with a 2.9  percent decrease in costs. We found that, in both the favorable and less  favorable scenarios, subsidy costs were not very sensitive to changes in  income-contingent repayment plans.
Percentage of Income  Contingent Repayment  Plans  Government borrowing  costs (discount rate)
Proportion of loan risk group  -13.0 (Increased  percentage of lowest risk  category)
0.4 (Increased percentage of  highest risk category)
Because Direct Loan costs are particularly sensitive to the government’s  cost of borrowing, total costs associated with the program will vary  accordingly. Further, since government borrowing costs change, the  eventual spread between those costs and the borrower interest rate will  not be known until the cohort is almost fully disbursed. As a result, the  interest income from borrowers may or may not offset the government’s  cost of borrowing at any given point in time.
section_title: Borrower Interest Rates Cannot Be Set in Advance to Consistently Balance Government Revenue with Direct Loan Costs
paragraphs: Since the total costs associated with Direct Loans, including  administrative and subsidy costs, are in flux until actual data are recorded  through the end of the loans’ life cycle, the point at which the government  covers loan costs without generating additional revenue—known as the  breakeven point—may also change throughout the life cycle of the loans  until actual information is available. As a result, borrower interest rates  that are needed to cover Direct Loan costs at one time may not cover  costs at another time. If the borrower rates are set to offset the expected  government costs according to initial estimates, because costs fluctuate,  it is likely that the cohort will not ultimately break even over the life of the  loans. For example, if costs are overestimated, borrower rates will be set  too high and the Direct Loans will generate net income to the  government. Likewise, if costs are underestimated, borrower rates will be  set too low and the Direct Loans will generate net costs to the  government.
Index: The base market rate to which student  loan interest rates are pegged.  Mark-up rate: The percentage-point increase  over the base rate that students are charged.
To determine whether or not the conditions that would break even for one  cohort would also break even for another cohort under different  circumstances, we experimented with certain aspects of the borrower  interest rate for two separate cohort years.  Specifically, we altered the  index (the base market rate that student loan interest rates are pegged  to), the mark-up rate (the percentage-point increase over the base rate  that students are charged), and the differences in the mark-up rates  among loan types. We looked at how these changes to the borrower rates  would affect total Direct Loan costs, taking into account both  administrative and subsidy costs.
We identified two potential pathways to temporarily break even for the  2014 cohort over the life of the loans, though these are only effective  using currently available cost estimates, which will change over time.
Using the 10-year Treasury Note as the index for all Direct Loan  borrowers without any additional mark-up—which means there would  be no differences in the interest rate borrowers pay for different loan  types—the government could approximately break even for the 2014  cohort. See Figure 6 below. In this case, setting a flat interest rate for  borrowers of all Direct Loan types is a notable divergence from  current law, which provides lower interest rates to eligible  undergraduates than to graduate students and parents. While there is  no mark-up above the 10-year Treasury Note in this scenario, the  government is still able to cover its estimated administrative and  subsidy costs because borrower interest rates (in this case, the index)  are higher than the government’s cost of borrowing.
Using the 5-year Treasury Note as the index instead of the 10-year   there can be slight differences in the interest rates  Treasury Note,borrowers pay for different loan types (unlike in the previous scenario  where rates were the same for all loan types), but in order to  approximately break even, the differences in the mark-up for each  loan type would need to be reduced by one half of the current rates  set for the 2014 cohort. Additionally, undergraduate Stafford loans,  which typically have the lowest interest rates, would need to be set at  the same level as the 5-year Treasury Note, with no mark-up.
Importantly, while changing the index and mark-up rates helped achieve a  temporary breakeven point for the 2014 cohort, the same borrower rate  scenarios did not yield the same results when applied to the 2019 cohort.  In other words, the breakeven methodologies used for the 2014 cohort  were not effective for the 2019 cohort. A difference in outcome for these  two cohorts emerges because Direct Loan costs are sensitive to variables  that are projected to look very different for 2019 than they did for 2014.  Specifically, while interest rates for the government’s cost of borrowing  were unusually low for 2014, they are projected to more than double by  2019, beginning to approximate pre-recession rates. This decreases the  spread between the borrower interest rate and the government’s cost of  borrowing, and therefore decreases the likelihood that the government  will generate income on the loans. Indeed, when we changed the index  and mark-up rates for the 2019 cohort in the same manner that  approximated a breakeven point for the 2014 cohort, the resulting  estimates show the government incurring costs that would not be covered  by revenues from Direct Loans. See figure 6.
While it would appear that borrower interest rates could be reset  frequently to adjust to the continually-changing spread between the  government’s cost of borrowing and the borrower interest rate that drives  costs, the fundamental issue of not having full cost information until the  end of the loan repayment period means that the breakeven point itself  cannot be accurately predicted beforehand. Accordingly, in part because  Direct Loan costs are sensitive to variables that change over time,  borrower rates cannot be set to reliably enable the program to break even  over the life of a loan cohort before those variables and cost estimates  stabilize.
section_title: Concluding Observations
paragraphs: Given the role federal student loans play in furthering access to  postsecondary education, the federal government has a stake in  preventing loan costs from posing an unnecessary burden to borrowers.  Understanding how Direct Loan costs are estimated and change over  time—and what factors drive those changes—is instructive for setting  borrower interest rates. However, available information illustrates the  difficulties of accurately predicting what these program costs will be, and  how much borrowers should ultimately be charged to achieve a particular  outcome. Specifically, fluctuations in the actual and expected costs of the  student loan program over time make it impractical to establish a  particular borrower interest rate that would consistently break even. In  addition, the policy changes needed to influence the costs of the program  could conflict with other policy goals. For example, setting a flat interest  rate for borrowers of all Direct Loan types may help temporarily  approximate a breakeven point, but it would be a considerable shift from  current law, which provides a lower interest rate to eligible  undergraduates. Similarly, making frequent changes to the borrower  interest rate could help program costs more closely match revenue in the  short term, but it may confuse potential borrowers and complicate efforts  to make the program transparent to students. Moreover, it may be difficult  to anticipate how any future policy changes might affect program costs,  as shifting economic conditions and cost reestimates continually move  the breakeven target. Understanding the uncertainties and substantial  challenges associated with estimating student loan costs may help inform  Congress as it considers how best to promote access to postsecondary  education.
section_title: Agency Comments and Our Evaluation
paragraphs: We provided a draft of the report to Education for review and comment. In  its comments, reproduced in appendix III, Education agreed with our  findings. Education also described recent changes to federal student aid  programs and noted the importance of the Direct Loan program, as well  as the agency’s focus on promoting greater college affordability and  access. In addition to these general comments, Education provided us  with technical comments that we incorporated, as appropriate.
We are sending copies of this report to the Secretary of Education,  relevant congressional committees, and other interested parties. In  addition, the report is available at no charge on the GAO website at  http://www.gao.gov.
If you or your staff have any questions about this report, please contact  me at (617) 788-0534 or emreyarrasm@gao.gov. Contact points for our  Offices of Congressional Relations and Public Affairs may be found on  the last page of this report. GAO staff who made key contributions to this  report are listed in appendix IV.
section_title: Appendix I: Objectives, Scope, and Methodology
paragraphs: This report addresses (1) how the costs of administering the Direct Loan  program have varied in recent years, (2) how estimated subsidy costs  associated with the Direct Loan program have varied in recent years, and  (3) how changes in different variables influence the overall cost of the  Direct Loan program and the borrower interest rate needed to cover those  costs. To address these objectives, we reviewed relevant federal laws  and guidance, as well as past GAO reports related to the Direct Loan  program, administrative costs, and subsidy costs. We interviewed officials  at Education and the Congressional Budget Office (CBO) regarding key  issues related to Direct Loan costs. In addition, we reviewed data from  Education on its Direct Loan administrative costs and analyzed data on  subsidy costs for fiscal years 2007 to 2012, including data generated from  Education’s Activity Based Costing (ABC) model and Education’s student  loan cash flow model. We assessed the reliability of data on Direct Loan  administrative costs to evaluate trends in costs by interviewing agency  officials knowledgeable about the data and reviewing documentation on  the ABC model. In addition to aggregate cost data, Education calculates  both direct and full unit costs using the ABC model. In order to report  costs that include indirect costs, we used full unit cost data. Education  officials noted that, in some cases, these data cannot isolate costs  specific to the Direct Loan program, from costs related to other Education  loan programs, because such data have not been necessary for  management purposes. We determined that the data were sufficiently  reliable for the limited purposes of this report. We have noted the  limitations in the report where they were relevant. For subsidy costs, we  analyzed data on Education subsidy cost estimates and reestimates for  the 2007 to 2012 Direct Loan cohorts that were reported in the Federal  Credit Supplement (part of the annual President’s Budget) to understand  trends in cost estimates and discern key cost drivers. Additionally, we  analyzed data generated by Education’s student loan cash flow model  used to estimate subsidy costs (referred to in this report as the Student  Loan Model) to understand trends in subsidy cost components and cost  drivers. We assessed the data’s reliability by reviewing relevant  documentation, comparing information to published data sources, and  interviewing agency officials knowledgeable about the data. We  determined that the data were sufficiently reliable for the purposes of this  report. Our work did not include an assessment of the feasibility of actions  that could be taken to reduce the impact of fluctuations in Direct Loan  cost estimates, such as using variable borrower interest rates that change  over the life of the loans, or the use of borrower rebates to offset any  subsidy income generated from the loans.
We conducted this performance audit from August 2013 to January 2014  in accordance with generally accepted government auditing standards.  Those standards require that we plan and perform the audit to obtain  sufficient, appropriate evidence to provide a reasonable basis for our  findings and conclusions based on our audit objectives. We believe that  the evidence obtained provides a reasonable basis for our findings and  conclusions based on our audit objectives.
subsections: section_title: Student Loan Model
paragraphs: Education uses the Student Loan Model to estimate future cost and  revenue cash flows by loan cohort. Data from the Student Loan Model are  input into OMB’s Credit Subsidy Model which, in accordance with FCRA,  calculates the net present value of the annual cash flows of a given loan  cohort, thereby obtaining a measure (subsidy rate) of the costs for each  loan cohort. According to an Education official, the model uses a set of  over 20 assumptions, including loan volume, defaults, and discount rates.  For each assumption, the model contains a table with multiple possible  values. The National Student Loan Data System (NSLDS), which  processes and maintains data pertaining to Title IV programs, is a major  source of the data for the assumptions used in the Student Loan Model.  Data are pulled from a 4-percent random sample of loans from the  NSLDS, and the data are calibrated by Education to generate  assumptions about future behavior. We assessed the reliability of NSLDS  data by reviewing existing information about the data and the system that  produced them. We assessed the reliability of the Student Loan Model by  reviewing model documentation and interviewing knowledgeable agency  officials about the system. We determined that the data were sufficiently  reliable for the purposes of this report. Education used the Student Loan  Model to run various scenarios and generate data for GAO for the  sensitivity and breakeven analyses described below.
section_title: Sensitivity Analysis
paragraphs: We worked with internal experts and Education to develop sensitivity  scenarios which altered key assumptions in the Student Loan Model to  illustrate how changes in certain variables could affect the overall cost of  the Direct Loan program. The four key variables we altered were: (1)  discount rates, (2) percentage of subsidized Stafford loans, (3)  percentage of risk category, and (4) percentage of income contingent  repayment plans. We selected the first three factors because Education  officials identified them as being among the major factors that affect  subsidy costs. We selected the percentage of income contingent  repayment plans because Education identified it as the type of repayment  plan most likely to face shifts in participation over time, particularly as  more people become eligible for various income contingent repayment  plans.  1.  Discount rate: This is the collection of interest rates used to calculate  the present value of cash flows that are estimated over a period of  years. This rate also represents Education’s cost of borrowing from  Treasury.  2.  Percentage of subsidized Stafford loans: Subsidized Stafford  Loans are available only to undergraduate student borrowers with  demonstrated financial need. The government subsidizes these loans  by not charging student borrowers for the interest that accrues while  they are still in school and during a 6-month grace period after leaving  school.  3.  Percentage of risk category: These categories were created using  school type and academic level to determine the potential risk of  default, which can lead to higher subsidy costs for the loans.  4.  Percentage of income contingent repayment plans: This is the  percentage of loans that are structured to prorate the repayment plan  based upon the borrower’s income. In the student loan model, there is  one variable that encompasses all repayment plans based on income.  These plans may result in increased subsidy costs.
We tested the sensitivity of costs under two types of scenarios:  1.  Favorable scenario: This scenario used past variable rates that  represented more favorable conditions in terms of reducing costs to  the government. For example, because income contingent repayment  plans have a higher subsidy rate than other types of repayment plans,  we used the lowest percentage of income contingent repayment plans  that existed from 2007-2012 in this scenario.  2.  Less-favorable scenario: This scenario used past variable rates that  represented less favorable conditions in terms of increasing cost to  the government. For example, because a higher discount rate  increases Education’s cost of borrowing from Treasury, we used the  highest discount rate that existed from 2007-2012 in this scenario.  See table 7 for the variable rates used in each scenario.
The scenarios forecast the overall cost of the Direct Loan program for  each variable alteration using the baseline of the fiscal year 2014 cohort  breakeven scenario (see below for a description of the breakeven  scenarios). The baseline scenario forecasted costs for the Direct Loan  program over the full life of the 2014 cohort, and include cash flow  projections 40 years into the future. Using this baseline, we altered the  variable rates to reflect historical values between 2007 and 2014, except  for the loan risk category, to see how the cost for the loan cohort was  affected.
section_title: Breakeven Analysis
paragraphs: We also worked with Education to change specific loan parameters in the  Student Loan model with the purpose of determining whether the  government could cover Direct Loan costs without generating additional  income under certain conditions. This is referred to as a breakeven  analysis. The following steps were taken to conduct this analysis:
First, the baseline subsidy rates for the 2014 cohort of Direct Loans  were calculated, excluding loan consolidations, using the index and  mark-up rates and caps as outlined by current law (see Table 8). We  selected 2014 because it was the next cohort to be disbursed at the  time of the simulation (September 2013) and allowed us to use  forecasted data for the hypothetical simulations. The agency provided  a breakout by loan type (Subsidized Stafford, Unsubsidized Stafford,  PLUS). An administrative cost rate is included in this analysis.
Scenario A: The interest rate mark-up was calculated that would be  necessary to get the federal subsidy income for the 2014 cohort to  cover estimated administrative costs (i.e. break even), still excluding  consolidations.
This scenario used the interest rate caps for each loan type and  the 10-year Treasury note for the index, as designated under  current law.
Separately, two breakeven analyses were conducted for the 2014  cohort with altered inputs. In both cases, caps were kept the same as  provided under current law.
Scenario B: 5-year Treasury Note with differentials in mark-up  rates between loan type as designated by the law.
Scenario C: 5-year Treasury Note with differentials reduced by  one half from the values designated in the law.
Scenario D: After finding the breakeven rates for 2014, the same  treatment of mark-up rates and differentials were applied to the 2019  cohort using the 10-year Treasury Note, still accounting for  administrative costs. We selected 2019 to show what the resulting  costs would be in a future year with different economic conditions (i.e.,  different discount rates).
Scenario E: The parameters for the 2019 cohort were then changed to  use the 5-year Treasury Note and reduced the differentials from  current law by one half (because those differentials helped  approximate a break even under the 2014 cohort estimate) to  illustrate how this affects costs.
Below is a summary of the loan parameters used for each breakeven  scenario.
section_title: Appendix II: Technical Appendix
section_title: Appendix III: Comments from the Department of Education
section_title: Appendix IV: GAO Contacts and Staff Acknowledgments
subsections: section_title: GAO Contact
section_title: Staff Acknowledgments
paragraphs: In addition to the contact named above, Kris Nguyen, Assistant Director;  Marcia Carlsen; Carol Henn; Elizabeth Gregory-Hosler; Amy Moran  Lowe; Ellen Phelps Ranen; Amrita Sen; Srinidhi Vijaykumar; and  Rebecca Woiwode made significant contributions to this report.
Also contributing to this report were James Bennett, Deborah Bland,  Jessica Botsford, Dan Concepcion, Holly Dye, Robert Dacey, Gary Engel,  Cole Haase, Susan J. Irving, John Karikari, Thomas J. McCool, Sheila  McCoy, Jean McSween, Brittni Milam, Mimi Nguyen, Omari Norman,  Debra Prescott, and Michelle St. Pierre.