A Student Loan Is Not Student Aid

fredgraph

So far, the United States is up to $1.4 Trillion in total student loan debt. Yet student loans are considered “Financial Aid” by the U.S. Department of Education. This is money that students will repay later, with interest, with their own money, at a profit to the government. Yet when people take out a car loan, no one calls it “aid.” Consumers will pay back their car loan, with interest, at a profit to the bank. The only difference between a car loan and a student loan is the entity making the profit.

“Subsidized” loans, which is simply the government guaranteeing repayment to itself, and deferred interest while in school is what usually distinguishes student loans from other types of loans. But are student loans truly subsidies?

All loans work like this: the lender (a government or a bank) gets cash at a discounted rate, and then re-sells that cash at an increased price, known as “interest.” The accumulated interested over time is the “cost” of borrowing the money for the consumer. It is also the source of profit for the lender.

So as soon as “discount rate,” and “time” come into the picture, we’re dealing with the time-value of money. The discount rate is simply the present value of money received in the future (cash flow). It’s calculated with 1/(1+r)^t. Where r=interest rates and t=time value

The government gets its money to sell cash to students through the bond market, usually in treasuries. The current 10-year Treasury yield is 2.42%, meaning that the government pays 2.42% as their cost of money. Then the government turns around and re-sells that loan to students at 6.3% (fixed), making a 3.88% profit.

There has been argument that student loans are “aid” because the government is re-selling the loans as a larger discount rate to students than the government receives. However, the math just doesn’t support this, especially when a) the government’s discount rate is the Federal Funds rate and b) that there is no arbitrage in government bonds as there can be in banking. Banks can sell bond coupons, or bundle corporate bonds into derivatives creating arbitrage. U.S. government securities have no coupons, and thus cannot be turned into derivatives. This means that unlike banks, the government pays no premium on the price of money.

For example, a $50,000 student loan (or a bunch of them) at 6.3% for 15 years, yields the government an extra $47,000, for a loan total $97,250. But the discount rate to student loans – the present value of future payments 15 years from now is 1/(1+.063)^15 = 2.50, which equals an extra 16 basis points per year. That means that the 6.3% interest really boils out to 6.46%. And that’s just on the interest!

Meanwhile, the government pays only the treasury yields as their cost of borrowing money to loan to students. None of this money comes out of the federal budget. All of the student loan money comes from credit markets vis-à-vis bonds.

Simply, there is no subsidy from the government that guarantees repayment to anyone but itself. And if students default? Then the government just created more government debt, which is easily offset by either fiscal or monetary policy.

In essence, the government guarantees student loans to itself, borrows money to lend money, and sells the money to students at a premium plus interest. This is exactly how car loans, and mortgages, are created. There is no subsidy, and thus, student loans are not aid.

What student loans really does for students is give them access to credit markets that students wouldn’t otherwise have access to in order to get an education. That’s an issue of constrained credit, not constrained wealth or cash. What bank in their right mind would lend $50,000 to an 18 year old with no job and no assets? Yet the amount of human capital generated over the life of that student is well beyond the $50,000. The student is paying their future earnings at a discount rate for an education now. That’s the same as getting a cashier’s check from the bank, and using it to buy a car. The difference is that the car dealer will try to upsell you. The financial aid department at your local college will likely treat you as someone looking for a handout.

And the sooner that the United States recognizes student loans as exactly that – loans – then the sooner that the United States can address its future student loan problem (arguably, crisis) instead of its future value of money.

 

Advertisements
This entry was posted in Econometrics, Public Policy. Bookmark the permalink.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s