Student Loan Programs: As Federal Costs of Loan Consolidation Rise, Other Options Should Be Examined
Released: 2003-12-01T00:00:00

Letter

Background

Congress created consolidation loans under Title IV of the HEA to help borrowers combine and reduce monthly repayments so as to help decrease federal loan default costs. Consolidation loans are available under Education’s two major student loan programs—the FFELP and FDLP. Under FFELP, private lenders make loans to students with Education guaranteeing the lenders loan repayment and a rate of return on the loans they make. Under FDLP, the federal government makes loans to students using federal funds.

FFELP and FDLP Offer Several Types of Loans

In addition to consolidation loans, a number of other types of loans are available under FFELP and FDLP, including subsidized Stafford, unsubsidized Stafford, and PLUS loans. Both subsidized and unsubsidized Stafford loans are variable rate loans that are available to undergraduate and graduate students. The interest rates borrowers pay on these loans adjust annually, based on a statutorily established market-indexed rate setting formula, and may not exceed 8.25 percent. To qualify for a subsidized Stafford loan, a student must establish financial need. Students can qualify for unsubsidized Stafford loans regardless of financial need. The federal government pays the interest on behalf of subsidized loan borrowers while the student is in school. Unsubsidized loan borrowers are responsible for all interest costs. PLUS loans are variable rate loans that are available to parents of dependent undergraduate students. The interest rates on these loans adjust annually, based on a statutorily established market-indexed rate setting formula, and may not exceed 9 percent. Parents can qualify for PLUS loans regardless of financial need.

Consolidation loans differ from Stafford and PLUS loans 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. Consolidation loans are new originations that, in general, do not contribute to increases in outstanding loan balances because they refinance already existing loans. 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 Stafford and PLUS loans. 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 (subsidized and unsubsidized Stafford loans, PLUS loans, and, in some instances, consolidation 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).

Consolidation loans under FFELP and FDLP accounted for about 44 percent of the $71.8 billion in total new student loan dollars that originated during fiscal year 2002. FFELP consolidation loans comprised about 72 percent of the fiscal year 2002 consolidation loan volume, while FDLP consolidation loans accounted for the remaining 28 percent.

Federal Credit Reform Act of 1990 Helps Define Federal Costs Associated with Consolidation Loans

The Federal Credit Reform Act (FCRA) of 1990 was enacted to require agencies to more accurately measure the government’s cost of federal loan programs and to permit better cost comparisons among and between credit programs, such as FDLP and FFELP. Prior to implementing FCRA, the budgetary cost of a new direct loan or loan guarantee was reported on a cash basis. Thus, loan guarantees appeared to be free in the budget year, while direct loans appeared to be as expensive as grants. As a result, costs were distorted and credit programs could not be compared meaningfully with other programs and with each other. FCRA and the related accounting standards and budgetary guidance, together known as credit reform, were established to more accurately measure the government’s costs of federal credit programs.

Subsidy Costs

As part of implementing credit reform, agencies are 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, based on the present value of estimated net cash flows, excluding administration costs.

For FFELP loans, the subsidy cost of a loan guarantee is the net present value, when a guaranteed loan is disbursed, of estimated cash flows such as: Payments by the government to lenders to cover loan defaults and interest subsidies. (Interest subsidies include payments to lenders that provide them a guaranteed rate of return on the loans they make as well as payments of interest on behalf of subsidized Stafford loan borrowers who are in periods of deferment).

Payments by lenders to the government, including origination and other fees, penalties assessed borrowers, and recoveries on defaulted loans. (For consolidation loans, FFELP loan holders must pay, on a monthly basis, a fee calculated on an annual basis equal to 1.05 percent of the unpaid principal and accrued interest of the loans in their portfolio.)

For FDLP loans, the subsidy cost of a direct loan is the net present value, at the time when the direct loan is disbursed, of estimated cash flows such as loan disbursements by the government to borrowers and principal repayments and payments of interest by borrowers to the government.

The subsidy costs of FDLP loans are also affected by the interest Education must pay to Treasury to finance its lending activities.

Administration Costs

Administration costs include all costs directly related to FDLP program operations, including loan servicing, loan system development and maintenance, including computer costs, and the costs of collecting on delinquent loans. For FFELP loans, lenders incur a substantial portion of administration costs. The federal government initially pays many of these costs by paying an allowance to the lenders. These allowances are part of the subsidy cost under credit reform. For FDLP loans, the federal government pays for administration costs directly.

Consolidation Borrowers Had More Debt, Higher Incomes, and Differed in Other Ways When Compared with Nonconsolidation Borrowers

Consolidation loan borrowers differed from nonconsolidation loan borrowers in a variety of ways. On average, consolidation loan borrowers had higher student loan debt, higher incomes, larger annual loan repayments, and longer repayment periods. They were also less likely to have attended a proprietary (or, for-profit) school and were more likely to have borrowed while attending graduate/professional school. In addition, they averaged more student loans from more lenders. Overall, consolidation loan borrowers defaulted less often than borrowers who had not consolidated their loans.

Consolidation Borrowers Had Higher Student Loan Debt and Incomes, Larger Loan Repayments, and Longer Repayment Periods

Borrowers with consolidation loans had a higher average amount of student loan debt than nonconsolidation loan borrowers. Prior to consolidation, the average student loan debt for our sample of consolidation loan borrowers from January 1987 through November 2002 was $21,735, more than twice the average of $9,587 for nonconsolidation borrowers (see fig. 1). While average student loan debt was higher for consolidation loan borrowers, the average student loan debt for both types of borrowers increased over time. Between 1992 and 2002, the average student loan debt increased from $17,420 to $35,339 for consolidation loan borrowers, and from $7,267 to $15,720 for nonconsolidation borrowers.

Borrowers with consolidation loans had higher average incomes and higher average annual repayments on their student loans than nonconsolidation loan borrowers. In addition, loan repayments comprised a slightly higher percentage of the incomes of consolidation borrowers, with an annual student loan repayment-to-income ratio of 9.4 percent for consolidation loan borrowers and 8.4 percent for nonconsolidation borrowers (see table 1). Not only did consolidation loan borrowers have higher average incomes than nonconsolidation loan borrowers, 39 percent of them had family incomes greater than $50,000, compared with 23 percent of nonconsolidation borrowers with family incomes greater than $50,000.

For the FDLP loans in our sample, consolidation loans tended to have longer repayment periods than nonconsolidation loans. Over 62 percent of consolidation loans had repayment terms of 12 years or more, compared with 26 percent for nonconsolidation loans. The smaller loan balances often carried by nonconsolidation loan borrowers could help explain why a smaller portion of nonconsolidation loans had repayment periods of more than 10 years. For example, under FDLP, many of the repayment plans that allow the extension of repayment periods require a minimum loan balance of $10,000. The repayment periods for loan balances over $10,000 usually vary depending on the amount of the loan, with 30 years being the maximum repayment period for loan balances of $60,000 or more. Since our analysis indicates that nonconsolidation loan borrowers had an average loan debt of $9,587, these borrowers would not qualify for extended repayment periods. However, even when consolidation loan borrowers had the option to extend their repayment term, nearly 4-in- 10 (37 percent) of the consolidation loans in our sample had a standard 10-year repayment period (see fig. 2).

Consolidation Borrowers Were Less Likely to Attend Proprietary Schools and More Likely to Have Borrowed While Attending Graduate/Professional School

Consolidation loan borrowers were less likely than nonconsolidation loan borrowers to have attended a proprietary (or, for-profit) school. Additionally, borrowers with consolidation loans were somewhat more likely to have attended public or private/nonprofit schools than were nonconsolidation borrowers. Overall, 80 percent of consolidation borrowers attended public or private/nonprofit schools and 74 percent of nonconsolidation borrowers attended a public or private/nonprofit school (see fig. 3).

Although both consolidation and nonconsolidation loan borrowers tended to borrow prior to graduate/professional school, our analysis indicates that consolidation loan borrowers were more likely than nonconsolidation borrowers to have taken out a student loan while attending graduate/professional school. About 28 percent of consolidation loan borrowers borrowed while they were in graduate/professional school compared with 12 percent of nonconsolidation loan borrowers (see fig. 4).

Consolidation Borrowers Had More Loans and Borrowed from More Lenders

Prior to consolidating their loans, consolidation loan borrowers averaged more loans from more lenders than nonconsolidation loan borrowers. Consolidation loan borrowers had taken out an average of about six loans each, nearly twice the average number for nonconsolidation borrowers (see fig. 5). Furthermore, consolidation loan borrowers were more likely to have borrowed from more than one lender. Prior to consolidation, 28 percent of consolidation loan borrowers had loans from three or more lenders compared with 9 percent for nonconsolidation borrowers (see table 2).

Consolidation Borrowers Defaulted Less Often

Fewer consolidation loan borrowers in our sample had defaulted on their consolidation loans than nonconsolidation borrowers had defaulted on their loans. The overall default rate for consolidation loan borrowers who had defaulted on their consolidation loans was about 8 percent compared with the overall default rate of 23 percent for nonconsolidation borrowers (see fig. 6).

Some consolidation loan borrowers had defaulted on a student loan prior to obtaining their consolidation loan and then subsequently defaulted on their consolidation loan as well. About one-fifth (19 percent) of consolidation loan borrowers had, in fact, defaulted on a loan before they obtained a consolidation loan; of these borrowers, about 23 percent subsequently defaulted on their consolidation loans. Of the approximately four-fifths (81 percent) of consolidation loan borrowers that had never defaulted on a student loan prior to obtaining a consolidation loan, about 5 percent defaulted on their consolidation loan.

Interest Rates and Increased Loan Volumes Have Increased Federal Costs

Although recent trends in interest rates and consolidation loan volumes have affected the FFELP and FDLP consolidation programs in somewhat different ways, the net effect has been an increase in estimated subsidy and administration costs for loans made in fiscal year 2003 as compared with loans made in fiscal year 2002. In FFELP, estimated subsidy costs rose from $1.3 billion for loans made in fiscal year 2002 to nearly $3 billion for loans made in fiscal year 2003. These estimated subsidy costs are affected by the amount the federal government must pay to lenders to guarantee them a statutorily established rate of return, which fluctuates over time as interest rates rise and fall. Increased FFELP consolidation loan volume in 2003 also raised costs. For FDLP consolidation loans, the margin of difference narrowed between the interest rate that Education earned from borrowers and the rate that Education paid to the Treasury to finance direct loans. As a result of this smaller difference, as well as an expected decrease in demand for FDLP consolidation loans compared to prior years, the estimated net interest gain to the government dropped from $460 million in fiscal year 2002 to $286 million in fiscal year 2003. The movement of subsidy costs for loans made in future years will depend heavily on what happens to interest rates and loan volumes. Administration costs are not specifically tracked for either loan program, but available evidence indicates that these costs have also risen.

Borrowers’ Rates Have Dropped and Loan Volumes Have Risen

Recent years have seen dramatic growth in loan volume for both consolidation loan programs, along with an overall drop in interest rates for borrowers that correspond to the overall decline in interest rates. From fiscal year 1998 through fiscal year 2002, the volume of consolidation loans made (or “originated”) rose from $5.8 billion to over $31 billion. Of the over $31 billion in consolidation loan volume for fiscal year 2002, $22.7 billion was in the FFELP and $8.8 billion was in the FDLP. While FDLP consolidation loan volume for fiscal year 2003 is expected to decrease, FFELP loan volume is expected to increase, resulting in a total consolidation loan volume of over $36 billion for the year. 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. From July 2000 to June 2003, the minimum fixed interest rate for consolidation loans dropped 4 percentage points, with consolidation loan borrowers currently obtaining rates as low as 3.50 percent in the year beginning July 1, 2003. Figure 7 shows the relationship between these two factors. Under these conditions, 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.

Underscoring the potential attractiveness of these loans to potential borrowers, many lenders, including newer loan companies that are specializing in consolidation loans, are aggressively marketing 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.

Effect on Subsidy Costs Varies between Programs

Overall estimated subsidy costs for consolidation loans made in fiscal year 2003 were greater than for consolidation loans made in fiscal year 2002. In light of the differences between how the FFELP and FDLP operate, however, the costs of these two programs were affected in very different ways. For FFELP, the result was a substantial increase in estimated subsidy costs. 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.

Increased Special Allowance Payments to Lenders and Increased Loan Volume Caused FFELP Subsidy Costs to Rise

Estimated subsidy costs for FFELP consolidation loans are expected to increase from $1.3 billion for loans made in fiscal year 2002 to almost $3 billion for loans made in fiscal year 2003. While part of the increase is the result of greater loan volume, the increase is primarily 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.

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. The amount of the quarterly SAP paid to loan holders equals the difference between the guaranteed lender yield and the borrower rate divided by four and multiplied by the average unpaid principal balance of all loans the lender holds. 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 nearly $3 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. In figure 8, the bottom line shows the fixed borrower rate for a FFELP consolidation loan made in the first 9 months of fiscal year 2003, while 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 would therefore receive only the rate paid by borrowers; no SAP would be 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 the figure 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.

In point of fact, Education is required to revise these estimates periodically to adjust for changing assumptions about interest rates and loan performance. Subsidy costs estimates for FFELP consolidation loans can vary substantially, depending on how much the guaranteed lender yield rises above the fixed rate paid by borrowers. Education is required to account for such changes in subsidy cost estimates by annually updating, or “reestimating,” loan program costs, in accordance with OMB budget guidance. Any increase or decrease in the subsidy cost estimates resulting from reestimates is reflected in future program budget estimates as appropriate and Education’s end of the fiscal year financial statements whenever the reestimated amount is significant. Thus, Education’s estimates for both fiscal year 2002 loans and fiscal year 2003 loans are subject to change in the future.

An increase in loan volume also played a role in the subsidy cost increase from fiscal years 2002 to 2003, but to a lesser degree than the higher interest subsidies the government is expected to pay to lenders. On their own, loan volumes can increase subsidy amounts. To illustrate, estimated subsidy costs can be converted into subsidy rates, reflecting the estimated unit cost per loan dollar to the federal government. For example, a $1,000 loan with a federal subsidy cost of $100 would have a subsidy rate of 10 percent. The subsidy rate for FFELP consolidation loans made in fiscal year 2002 was approximately 5.9 percent. Given a fiscal year 2002 FFELP consolidation loan volume of about $22.7 billion, and a subsidy rate of 5.9 percent, federal subsidy costs can be determined by multiplying the loan volume by the subsidy rate ($22.7 billion X 0.059 = $1.3 billion). Viewed in this way, it is clear that even if the subsidy rate remained the same from fiscal year 2002 to 2003, the larger expected FFELP consolidation loan volume of $30.5 billion in fiscal year 2003 would have increased total subsidy costs to $1.8 billion (i.e., $30.5 billion X 0.059 = $1.8 billion), an increase of $0.5 billion from fiscal year 2002. However, the higher interest subsidies the government is expected to pay to lenders, as previously discussed, also increased the subsidy rate for FFELP consolidation loans made in fiscal year 2003. This rate—9.8 percent— coupled with the estimated loan volume of $30.5 billion, resulted in the total FFELP consolidation loan subsidy costs of about $3 billion ($30.5 billion X 0.098).

Changing Interest Rates Also Affected FDLP Consolidation Loans

Subsidy costs can occur within FDLP as well, but in a different way. The FDLP consolidation program is a direct loan program and therefore involves no guaranteed yields to private lenders. Still, the program has potential subsidy costs determined in part by the relationship between interest rates Education earns from borrowers—the borrower rate and the rate Education pays Treasury to finance its lending. The government’s cost of capital 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 is expected to decline from $460 million in fiscal year 2002 to $286 million in fiscal year 2003.

The smaller net gain that is expected to occur in fiscal year 2003 reflects a narrowed difference between the discount rate and the borrower rate. 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 2 percentage points, from 6 percent in fiscal year 2002 to 4 percent in fiscal year 2003. The discount rate, on the other hand, dropped by only 0.95 percentage points. The resulting interest rate spread decreased from 1.1 percent to 0.05 percent (see table 3). In other words, each $100 of consolidated FDLP loans made in fiscal year 2002, will result in $1.10 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 $0.05 more in interest for the government.

While Education revises estimates periodically to adjust for changing assumptions about future interest rates for FFELP consolidation loans, the borrower rate and the discount rate used to derive the subsidy cost for FDLP consolidation loans made in fiscal year 2003 are generally fixed for the life of the loans. As a result, the subsidy cost of FDLP consolidation loans made in any given fiscal year do not vary in the way that subsidy costs for FFELP consolidation loans do.

Loan volume also played a role in the smaller net gain that occurred in fiscal year 2003. While FDLP consolidation loan volume increased from about $5.4 billion in fiscal year 2000 to about $8.8 billion in fiscal year 2002, Education estimated a decrease in demand for FDLP consolidation loans for 2003, expecting volume to be about $6 billion. The unit cost per loan dollar, or subsidy rate, for FDLP consolidation loans made in fiscal year 2002 was a negative 5.2 percent, which resulted in a negative subsidy—that is, a “gain”—to the government of $0.052 for each dollar lent (excluding administrative costs). As previously discussed, the difference between the discount rate and the borrower rate narrowed from fiscal year 2002 to fiscal year 2003, which contributed to the increased subsidy rate from a negative 5.2 percent to a negative 4.8 percent, resulting in a smaller gain, per loan dollar, to the government. Had the subsidy rate remained the same from fiscal year 2002 to fiscal year 2003, the decrease in FDLP consolidation loan volume would have resulted in a reduced gain to the government of about $147 million. The subsidy rate increase from fiscal year 2002 to fiscal year 2003, however, coupled with reduced loan volume, resulted in a reduced gain of $174 million.

Subsidy Costs Are Sensitive to Interest Rate Changes

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. As a measure of how great an effect different interest rate assumptions can have, we asked Education to conduct two additional sets of calculations for fiscal year 2002 FFELP and FDLP consolidation loans. Using the same loan volume and other assumptions of the fiscal year 2002 estimates, Education applied the interest rate assumptions that were used to develop the estimates for the fiscal year 2001 and 2003 consolidation loans. These assumptions differed from those in place in fiscal year 2002, as well as from each other. In general, the interest rate assumptions for fiscal year 2001 were higher than the assumptions used in fiscal year 2002, and future interest rates were expected to decrease. The interest rate assumptions for fiscal year 2003, on the other hand, were generally lower than the assumptions used in fiscal year 2002, and future interest rates were expected to increase.

Calculating subsidy estimates under these three different sets of interest rate assumptions produced substantially different results. As figure 9 shows, the results of this analysis indicated that for FFELP consolidation loans, the fiscal year 2001 interest rate assumptions would result in estimated subsidy costs totaling $129 million, or about $1 billion less than the estimated subsidy costs under the actual fiscal year 2002 estimates. In contrast, the fiscal year 2003 interest rate assumptions resulted in estimated subsidy costs totaling $2.4 billion, an increase of more than $1.2 billion in subsidy costs, even though the estimate was calculated across the same volume of loans. For FDLP consolidation loans, the analysis indicated that a greater interest rate spread between the discount rate and the borrower rate for the fiscal year 2001 interest rate assumptions, resulted in a net gain to the government totaling about $645 million or about $264 million more than the gain under the actual fiscal year 2002 estimates. In contrast, the fiscal year 2003 interest rate assumptions resulted in an estimated subsidy cost to the government totaling about $370 million, a change of about $751 million. This increase is primarily due to the negative interest rate spread in which the borrower rate used in fiscal year 2003 was less than the discount rate used in the fiscal year 2003 interest rate assumptions.

Administration Costs Also Increase, but Mainly Because of Loan Volume

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 total includes approximately $31 million for loan origination, $19 million for loan servicing, and $3 million for loan collection. The $52.3 million does not include overhead costs, which include such expenses as 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 by about $7 million 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 under FFELP, a large portion of 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.

Repayment Options Other Than Consolidation Loans That Allow Borrowers to Simplify Loan Repayments and Reduce Repayment Amounts Exist, but Borrowers’ Use of These Options Is Limited by Several Factors

Repayment options, other than consolidation loans, that allow borrowers to simplify loan repayment and reduce repayment amounts are now available to some borrowers under both FFELP and FDLP, but these alternatives are not available to all borrowers. Since consolidation loans were first offered to borrowers, Congress has changed student loan programs in ways that provide borrowers with these loan repayment options. These options include provisions for combining multiple loan payments into one and for restructuring the repayment terms or lengthening the repayment period in order to lower monthly repayment amounts. However, these options are limited, in some cases, to borrowers who have loans with one lender, or whose loan balances meet certain criteria. These options also differ from the consolidation loan program in that they carry a variable borrower interest rate, while consolidation loans allow borrowers to lock in a fixed interest rate. In today’s environment, with current low interest rates that are expected to rise over time, the ability to lock in a low fixed rate may affect many borrowers’ decisions about which approach to take. Borrowers’ choices of whether to use consolidation loans or these other options have a budgetary effect for the federal government. Proposed legislation has been introduced in the 108th Congress that, among other things, would replace the fixed borrower interest rate for consolidation loans with a variable interest rate.

Flexible Repayment Options Similar to Consolidation Are Available to Some Borrowers

Other options, outside of consolidation, now exist for some borrowers to make single payments on multiple loans and reduce their payment amounts—options that were unavailable when Congress first introduced consolidation loans under the FFELP. For example, when Congress created the FDLP in 1993, Education provided FDLP borrowers with the ability to combine payments on multiple FDLP loans into a single payment. Similarly, in 1999, Education promulgated regulations requiring FFELP lenders to combine all of a borrower’s FFELP loans into a single account to be repaid under a single repayment schedule. Furthermore, Congress has provided borrowers with a number of repayment plans that give certain FFELP and FDLP borrowers who do not consolidate their loans flexibility to reduce monthly payment amounts in a variety of ways. For example, “graduated” and “income-sensitive” repayment plans introduced in 1992, allow borrowers to make smaller payments early in a repayment period, followed by larger payments in future years. (These plans assume that a borrower’s income will increase over the repayment period.) While borrowers who use the FFELP graduated and income- sensitive repayment plans must generally repay their loans over a 10-year period, another repayment plan—“extended”—allows certain FFELP borrowers to lengthen their repayment terms up to 25 years, thus reducing monthly repayment amounts. Under FDLP, borrowers have similar repayment options, plus additional flexibility to repay loans over longer periods, outside of consolidation. Table 4 summarizes the repayment plans available to borrowers under FFELP and FDLP.

Consolidation loan borrowers, like other FFELP and FDLP borrowers, may choose among the four repayment plans offered under the programs. Borrowers who consolidate under FFELP may—in addition to flexibility offered by the repayment plans—extend their repayment periods up to 30 years by choosing a standard, graduated, or income-sensitive repayment plan. Extending repayment periods, in general, will lower borrowers’ monthly repayment amount. Table 5 compares the repayment periods allowed by FFELP under consolidation with those allowed under nonconsolidation.

Compared with FFELP borrowers, FDLP borrowers have more flexibility to extend the repayment periods for FDLP loans without obtaining a consolidation loan. Under the graduated and extended repayment plans, for example, FDLP borrowers may obtain a repayment period of up to 30 years, regardless of whether they choose a consolidation loan or nonconsolidation option. Table 6 shows the repayment periods available for FDLP borrowers.

While the options, outside of consolidation, allow some borrowers to make single repayments on multiple loans and reduce their monthly repayment amounts—thus achieving ends similar to consolidation loans— not all borrowers can take advantage of these flexibilities. First, borrowers who obtained FFELP loans from multiple lenders are still faced with making multiple loan payments because lenders are only required to combine borrowers’ repayments on the loans they make. Second, borrowers may be required to meet certain eligibility criteria—such as accumulating loans exceeding specified thresholds—to qualify for extended repayment periods. Finally, borrowers who obtained loans under multiple programs—FFELP, FDLP, or other programs—are also faced with multiple payments and may or may not be able to obtain lower monthly repayment amounts. Table 7 compares the extent to which borrowers can combine multiple loan payments into one, lower monthly repayment amounts, and extend repayment periods under consolidation and nonconsolidation options.

Available Options Involve Variable Interest Rates, While Consolidation Offers Currently Attractive Fixed Rate

Another key difference between consolidation loans and other repayment options for nonconsolidation loans is that these other options carry a variable interest rate, while consolidation loans carry a fixed interest rate for the life of the loan. Depending on prevailing interest rates and borrowers’ expectations about future interest rates, this difference may affect the decisions that borrowers make regarding whether to obtain a consolidation loan or use other options to combine payments, lower payments, and extend repayment periods. When interest rates are low, as they are now, and are expected to increase in the future, a consolidation loan that carries a low fixed interest rate may be more attractive to borrowers because a variable rate may exceed the fixed rate during most or all of the remaining repayment period, which could be up to 30 years. However, if rates are expected to decrease in the future, repayment options that carry a variable rate may be more attractive, and borrowers may choose other options over consolidation, hoping to take advantage of lower rates in the future. Since it is difficult to predict interest rates over a lengthy period, borrowers need to be aware of all the risks involved before they make their final decision. Once student loans are consolidated, the interest rate is fixed for the life of the loan and, under current law, borrowers generally cannot reconsolidate their existing consolidation loans to take advantage of lower interest rates. Consequently, borrowers who chose to consolidate their student loans several years ago—and locked in what are now high rates relative to what borrowers can now obtain—are unable to take advantage of the current rate. For example, borrowers who consolidated between February and June 1999, have a locked rate of 8.25 percent. Borrowers who elected to consolidate between July 2002 and June 2003 received a rate of 4 percent, and for 2004, the rate is expected to be about 3.5 percent.

Borrowers’ Choices between Fixed or Variable Rate Alternatives Affect Federal Costs

The choices that borrowers ultimately make will have consequences for federal costs. As previously discussed, federal costs for FFELP consolidation loans have recently increased because of the greater difference between borrowers’ fixed low interest rate and the variable rate guaranteed to lenders, which is expected to increase in the future. In this situation, were borrowers to choose an alternative option, costs to the federal government would likely be less because a variable borrower rate would increase along with the variable rate guaranteed to lenders and the difference between the two rates would be less. This decreased difference would result in decreased FFELP federal subsidy costs. If circumstances were different, however, federal subsidy costs could increase. For example, if borrowers obtained a consolidation loan with a fixed interest rate at a time when rates were expected to decrease in the future, federal subsidy costs would be lower, than is currently the case, because the borrower rate would likely exceed the rate guaranteed to lenders, and the federal government would not be required to pay a SAP. In such situations, if borrowers were to choose an alternative option with variable borrower rates, federal subsidy costs could increase because the borrower rate would decline along with the variable rate guaranteed to lenders. In this case, the decreased difference could result in increased FFELP federal subsidy costs, if SAP payments became necessary.

Borrowers’ choices between fixed and variable rate loans and among repayment periods also affect costs to the federal government associated with FDLP loans. A significant driver of FDLP costs, as previously discussed, is the difference between the discount rate and the borrower rate. In general, higher borrower rates will result in Education receiving larger interest payments from borrowers, thus decreasing federal costs. 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. For both programs, federal costs are also affected by the repayment period chosen by borrowers. For example, longer FFELP repayment periods can result in the federal government making special allowance payments to lenders over a longer period of time. For FDLP, longer repayment periods can increase the amount of interest borrowers pay to Education on their loans and increase the amount of interest paid by Education on the amounts borrowed from Treasury.

Proposed Legislation Concerning Consolidation Loans Could Affect Federal Costs

Proposed legislation has been introduced in the 108th Congress that, among other things, would replace the fixed borrower interest rate for consolidation loans with a variable interest rate, which will affect federal costs associated with consolidation loans. In particular, the Student Loan Fairness Consolidation Act of 2003 (H.R. 2504) would eliminate provisions that prevent borrowers who previously obtained a consolidation loan from obtaining a new consolidation loan and replace the current fixed borrower rate with a variable borrower rate for borrowers who refinance their existing consolidation loans as well as for new consolidation loan borrowers. For example, borrowers who obtained a consolidation loan in the past and are paying higher rates of interest would be provided the opportunity to obtain a new consolidation loan at current (lower) borrower interest rates. In addition, in “re-consolidating” their loans, the proposed legislation would replace the current fixed borrower rate with a variable borrower rate. If enacted, the proposed legislation would affect federal costs due to the refinancing of previous consolidation loans and the change from fixed to variable borrower interest rates.

Conclusion

Although additional options to consolidation are now available that give some FFELP and FDLP borrowers opportunities to simplify loan repayment and reduce repayments to more manageable levels, not all borrowers qualify. As a result, many borrowers may find that consolidation loans remain the only option for combining loans and lowering their monthly repayments. While consolidation loans may thus remain 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 for FFELP consolidation loans. Providing for these larger interest subsidies on behalf of a broad spectrum of borrowers, however, 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. 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. 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 changes 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.

Recommendation for Executive Action

We recommend 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. Options 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. 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. If Education determines that statutory changes are needed to implement more cost-effective repayment options, it should seek such changes from Congress.

Agency Comments

We provided a draft of this report to Education for review and comment. In commenting on the draft, Education agreed with our reported findings and recommendation, noting that our work will contribute to the policy discussions related to the reauthorization of the HEA. In addition, Education noted that it was pleased with our conclusion that consolidation loans have advantages for borrowers and may help them avoid default and that improving flexible repayment options for borrowers would provide several benefits. Education also provided technical comments, which we incorporated where appropriate. Education’s written comments appear in appendix I.

As agreed with your offices, unless you publicly announce its contents earlier, we plan no further distribution of this report until 30 days from its issue date. At that time we will send copies to the Secretary of Education and other interested parties. We will also make copies available to others upon request. In addition, the report will be available at no charge on GAO’s Web site 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 contacts and staff acknowledgments are listed in appendix II.

Appendix I: Comments from the Department of Education

Appendix II: GAO Contacts and Staff Acknowledgments

GAO Contacts

Staff Acknowledgments

In addition to those named above, Cindy Decker, Ben Jordan, Heather Macleod, Corinna Nicolaou, Stan Stenersen, Vanessa Taylor, and Marcia Carlsen made important contributions to this report.