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

Letter

Background

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.

Types of Direct Loan Costs

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.

Direct Loan Administrative Costs

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.

Direct Loan Subsidy Costs

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.

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

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

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.

Costs per Borrower and Other Unit Costs Have Generally Remained Stable or Fallen

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.

Estimated Subsidy Costs Differ across Loan Cohorts and Fluctuate over Time

Subsidy Costs Vary by Loan Cohort, and Current Estimates Show the Government is Expected to Generate Subsidy Income from Recent Cohorts

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.

Subsidy Cost Estimates Fluctuate over Time Due to Regularly-Updated Data

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.

Because Direct Loan Costs Are Sensitive to Certain Variables, Borrower Interest Rates Cannot Be Set in Advance to Consistently Balance Government Revenue with Costs

Direct Loan Costs Are More Sensitive to Changes in Government Borrowing Costs than to Other Selected Variables

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.

Borrower Interest Rates Cannot Be Set in Advance to Consistently Balance Government Revenue with Direct Loan Costs

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.

Concluding Observations

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.

Agency Comments and Our Evaluation

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.

Appendix I: Objectives, Scope, and Methodology

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.

Student Loan Model

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.

Sensitivity Analysis

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.

Breakeven Analysis

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.

Appendix II: Technical Appendix

Appendix III: Comments from the Department of Education

Appendix IV: GAO Contacts and Staff Acknowledgments

GAO Contact

Staff Acknowledgments

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.