Tough Choices Ahead – the Coming Catastrophe for Financial Aid

While all eyes anxiously wait to see whether Congress and the administration can reach agreement to avert the fiscal cliff, federal financial aid faces a fiscal cliff all its own. 

As reported by Inside Higher Ed and several other sources, the Pell Grant program, the foundation of federal financial aid for low-income (and increasingly, moderate income students) faces a fiscal cliff all its own.  At the end of the current fiscal year, the program will face a $6 billion gap between what’s available and what’s needed for the subsequent fiscal year.  Compounding the problem is the July 1, 2013 deadline when subsidized Stafford loan rates are slated to increase to 6.8 percent.  If that were all, it may be manageable as a number of options exist to trim spending from financial, but the president’s income-based repayment (IBR) program is making it even harder for Congress to make ends meet for federal financial aid.

That’s important, as one problem facing Congress is that there just aren’t very many places to squeeze more money from the student aid programs.  Last year, at the administration’s urging, Congress cut interest subsidies for graduate students and eliminated the six-month grace period for all borrowers.  These changes created $20 billion in savings over the next decade (by making student loans more expensive for borrowers) but couldn’t cover the roughly $60 billion gap the Pell grant program faces over the same period.  Additional savings will have to be found or significant changes will need to be made to the Pell grant program to make it viable.

One potential solution getting some attention in recent days would be to end the subsidized Stafford loan program and have those borrowers enter IBR instead.  Subsidized Stafford loans do not allow interest to capitalize while a borrower is still in school, a unique benefit that is also retained later, should the borrower enter deferment later during their repayment period.  As proponents of the idea have already noted, the proposal would be virtually certain to face massive criticism from student aid advocates.  Still, the move would theoretically save billions of dollars that could be used to shore up the Pell grant program or reduce borrower rates.  For that reason the proposal, on its face, seems reasonable.  After all, the benefit from preventing interest from capitalizing until after a student enters repayment isn’t as large a benefit as what’s available through IBR, and eliminating subsidized Stafford loans could save as much as $50 billion over a decade, which would help lower income students by preserving a stable Pell grant program.

That’s where the problem reaches a pivotal point, however.  According to the White House’s own projections, IBR is expensive.  Really expensive.  A lot more expensive even than subsidized Stafford loans, capped at 3.4 percent interest rates.  According to the White House’s fiscal year 2013 budget, the subsidy cost (cost per dollar loaned) for loans in IBR is substantially higher than the costs of subsidized Stafford loans in any other repayment plan.

Table 1 – Subsidy Cost Estimates for Subsidized Stafford Loans, by Type of Repayment Plan

Source: President’s Fiscal Year 2013 Budget

The same is true for unsubsidized Stafford loans.

Table 2 – Subsidy Cost Estimates for Unsubsidized Stafford Loans, by Type of Repayment Plan

Source: President’s Fiscal Year 2013 Budget

The impact of eliminating subsidized Stafford loans sets two concurrent budget processes in motion.  First, eliminating the subsidized Stafford loan program would save money because unsubsidized Stafford loans are substantially less expensive to the government.  Where subsidized Stafford loans in standard repayment would make around $100 million for every $10 billion loaned for the government, those same loans issued as unsubsidized Stafford loans would save the government $2.7 billion.  However, the second, and equally important point, is that once those unsubsidized loans shift into IBR, the projected cost to the government explodes, completely erasing any projected savings and adding considerably to the deficit.  Rather than making $2.7 billion for the government, those same $10 billion in loans would cost $1.5 billion, a $4.2 billion swing. 

This means that eliminating subsidized Stafford loans and shifting those borrowers into IBR is unlikely to produce any real savings at all.  Quite the opposite, in fact.  As more borrowers leave other forms of repayment to enter IBR, the cost to the federal government becomes a monstrous debt trap.  The subsidized Stafford loan portfolio is projected to grow by $32 billion in fiscal year 2013.  Assuming no changes in demand or increases in loan availability, that could grow to $320 billion in new subsidized Stafford loan obligations.  Over the next decade, if the same cost relationship holds true, the IBR program would cost the government $50 billion as unsubsidized Stafford loan borrowers shift their loans out of alternative repayment plans (more advantageous to the Treasury) into IBR.

In other words, Congress is facing a tougher dilemma than is immediately obvious.  The holes dug through the massive expansion of the Pell grant program and the president’s rush to usher in more generous IBR terms are only getting deeper.  In order to extend Pell’s viability, keep borrower interest rates down, and maintain the IBR benefit promised to millions of borrowers, Congress is going to have to come up with $150 billion more than is budgeted for the financial aid programs right now over the next decade.  It’s hard to see in the current environment how Congress and the president can do that, particularly if they somehow manage to avert jumping over the fiscal cliff on January 1.