The government is getting 7% or more on many student loans, which are almost impossible to get rid of, even in bankruptcy. It's creating a debt problem that could leave the mortgage crisis far behind, writes MoneyShow's Terry Savage.

Federal student loans are about to become a larger financial crisis than the mortgage disaster. With $1 trillion in student loans outstanding—and more being added every year—cutting the interest rates on Federal student loans is a topic that both parties should agree upon immediately.

If the law hadn’t been changed in 2006, college grads would today be repaying their loans today at a rate of 0.25%!

That’s not a typo. The interest rate on Federal student loans would be one-quarter of 1% under the original student loan repayment formula. Instead, most Stafford student loans today are repaid at an interest rate of 6.8%, while subsidized Stafford student loans pay “only” 3.4%.

Meanwhile, the Federal government borrows money to pay its debt at an interest rate of 0.1% (one-tenth of 1%)—the rate they pay on 90-day Treasury bills. And until seven years ago, that T-bill rate was used to calculate student loan repayment rates.

For a government that says it wants to encourage an educated population, it is the height of hypocrisy to change college students an interest rate that is so far above rates on Treasuries—and even mortgages. Remember, no one can escape student loan repayment. Even bankruptcy does not wipe out student loan debt.

The Rate Ripoff
Until the student loan repayment formula was changed seven years ago, the student loan interest rate changed every July 1 based on the Treasury bill auction rate set at the end of May, rounded up to the next 0.25%. That would put today’s repayment rate at 0.25%. And, graduates had a one-time chance to lock in the repayment rate for the life of the loan!

But on February 8, 2002, President Bush signed legislation changing the interest rates on education loans from variable rates to fixed rates for new loans issued after July 1, 2006.

The current fixed rates, which have been in effect for the past two years, are: 6.8% on unsubsidized Stafford loans and 3.4% on subsidized loans (meaning no interest accrues during college years, on these loans which are based on need). Parental Plus loans also carry a fixed rate—an incredible 7.9%!

The result is a huge repayment debt that can hang over a college graduate’s life for many years. The higher rates add a small fortune to the debt that must be repaid.

Here’s an example. Let’s use a Federal student loan debt of $31,000—which is the maximum that can currently be borrowed in Federal student loans over a four-year college career. Let’s assume a ten-year repayment schedule.

And just to be fair, let’s not use the “old formula,” which would have the loan repaid at a 0.25%. Instead, let’s use the rate the government pays today on ten-year Treasury notes, and round it up slightly to 1.75%.

  • At the current repayment interest rate of 6.8%, the monthly payment on that loan would be $356.75. And the total repaid over ten years would be $42,809.33—of which $11,809.33 is interest.
  • At a rate of 1.75% on that student loan, the monthly payment would drop to $284.63. And the total repaid would drop to $34,155.68—of which the total interest would be only $3,155.68.

Today’s students would save a fortune in interest if they only paid the same rates that the Treasury pays to borrow for ten years. And since Federal student loans are now made directly by the government, and the government will get repaid on those loans eventually (even if they have to deduct the amount from your Social Security payments in your old age), don’t you think they should charge a more reasonable rate?

The Student Loan Lesson
Of course, all of this would be a less important discussion if today’s college grads were leaping into an economy that offered plenty of good-paying jobs and opportunities for advancement. That’s certainly not the case, and hasn’t been for the past few years. So it should make students and their parents rethink their college plans.

A higher education will certainly pay off in the long run, as America recovers and moves ahead in the global economy. But in the short run, student loan debt will be an increasingly heavy burden. That means students have to re-think the kind of education they need, and how they should pay for it. And parents have to rethink how they save, and help pay for college.

Suddenly, a four-year college education at a distant campus doesn’t look as sensible as two years living at home and attending junior college, before transferring to get your degree at a university. Now, attending class over the summer so you can graduate in three years, and save a year of living expenses, looks like a much better deal.

With current rates, it doesn’t make sense for parents to take a Federal PLUS loan, or co-sign a private student loan, at much higher rates. Home equity loans are fine if you still have equity—and don’t fear higher rates in the mortgage market. But raiding your retirement funds in the hopes that your son or daughter will support you in your old age does not make sense at all!

And finally, the politicians should stop being hypocrites. The government makes all Federal student loans directly, so no one makes (or loses) money on the deal but the taxpayer. There should be more process to qualify for Federal student loans, and more education about the costs of repayment. And the lender—our government—should set fairer repayment terms.

That’s the approach we need if we really want an educated populace. And it’s something Americans should demand of both political parties. That’s the Savage Truth.