Sunday, June 26th, 2022

US student debt: what will the interest rate cut on loans mean?

The rise in US student debt and the recession caused by COVID-19. What is the use of cutting student loan rates? 

In the United States, the cost of education is significantly higher than in the rest of the world: most nations finance education spending directly, while student loans play a significant role in US higher education. Nearly 20 million American students attend college each year, of which nearly 12 million take out a loan annually to help cover their costs. 

According to data reported by the Federal Reserve, the total number of underwriters of a federal debt amounts to 42.3 million borrowers, while the total debt, which is constantly increasing, amounts to about 1.67 trillion dollars (more than triple compared to 2006 ). The average student debt is approximately $ 37,000. According to Federal Student Aid data, 92% of these loans, about 1.54 trillion, are owned by the US Department of Education. The market essentially functions as a government program rather than a private market. 

Federal education funding is the most popular because it has a lower interest rate than a private loan. In addition, the federal loan rate is set annually by Congress by law. Private loans are a small part of the debt, accounting for 7% of the total loan volume, approximately $ 115 billion. 

THE RELATIONSHIP BETWEEN THE INTEREST RATE AND STUDENT LOANS 

Congress changes (or leaves unchanged) interest rates on federal loans every July 1st. 

College students do not graduate ( undergraduate ) generally they can not accumulate huge amounts of federal debt. An employee student, that is, an undergraduate, unmarried student, who is under the age of 24, by borrowing the maximum allowable federal loan each year, for four years, would have accumulated $ 27,000 in debt; for independent students, the total would be $ 45,000. 

Many students can take up to five or six years to complete a four-year degree, but they can’t borrow more than the limit. Graduated students, on the other hand, have much higher loan limits ($ 20,500 per year). 

In 2020, in times of coronavirus, interest rates on subsidized loans fell from 4.53% to 2.75% on direct loans to college students, while rates on unsubsidized direct loans for graduate students fell from 6, 08% to 4.3%. 

This cut was exactly what was expected, as Congress tends to cut interest rates when inflation is high, while in a period of low inflation it tends to raise interest rates. The interest rates on loans have therefore largely adapted to the economic trend, falling in times of crisis and rising in more prosperous times. 

Rates were cut substantially in the early 2000s ( Dot-com Bubble ) and during the subprime mortgage crisis. In both cases, there has been an increase in enrollment from both public and private universities. In 2002 there was a “boom” of members of + 6.69% compared to the previous year, while in 2009 there was an increase of + 7.07%, against an average increase of 1.82% in twenty-five years. 

In the years just mentioned, if we look at the simple relationship between the increase in the enrollment rate and the increase in loans as a function of the change in federal interest rates, we note that this ratio has increased from 70% in 2008-2009, when the Subsidized loan rate was 6%, rising to 86% in 2011-12 when the rate dropped to 3.4%. 

In recent years, therefore, the request for loans has increased significantly both concerning the number of subscribers and in proportion to the request for other loans. 

However, this evidence is not found by a branch of the economy called Behavioral Finance. Behavioral Finance tends to disprove the causality between the two events, as there are no known empirical studies that estimate a causal relationship between college enrollment and the interest rate charged on loans. An interest rate “discount” may not be considered tangible when students decide to enroll in college, as they will still receive the same funds regardless of the loan interest rate, whether it is 2%, 4%, or 10%. 

It will be interesting to see if the lower interest rate recorded during this period will translate into higher loan shares. 

WHERE THE REAL PROBLEM LIES 

Education is an investment, and like all investments, it creates costs in the present but offers benefits in the future. 

An important aspect is to understand if college is a profitable investment for most students and if in the long run, the benefits are greater than the debt achieved. 

Borrowers were told that after higher education, advanced skills would translate into higher earnings and better employment opportunities. In many cases, this has not happened, and many generations of borrowers are trapped in debt. 

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