This article uses fixed-income knowledge to analyze the current student loan debate
Student loan debt is a big topic in the news right now so I thought it would be interesting to apply some Fixed Income Knowledge to the issue. In this article, I’ll analyze the student loan debate with four different scenarios: (1) do nothing, (2) reduce interest rates on student loans, (3) subsidize interest rates, (4) apply partial principal forgiveness.
The reason why the student loan debate is interesting for fixed income is because student loans are a basic amortizing product. Essentially, a student borrows money and makes stable monthly payments throughout the life of the loan, which includes both principal and interest.
A key feature of an amortizing assets is that in the beginning, the payments are going primarily to pay down interest and will do little to decrease the overall principal balance. The principal balance will more rapidly decrease the closer you get to maturity. Anyone who has ever spent five years paying down their student loans only to see that the principal has barely decreased should be familiar with this concept.
As with any amortizing asset, when you reduce the interest rate on the loan, you reduce the overall monthly payment and increase the amount of principal paid down per payment. Currently, the average interest rate on government and private student loan is ~8.00%. Private student loans shouldn’t be disregard since they are products that students rely on to finance their education. Even if you look at just federal student loans, the interest rates can be over 7.5% and will likely increase as the Fed is pushing rates higher. The reason I’m throwing all these interest rates at you is because the U.S. government can borrow at very low rates, and it is currently issuing student loans at massive spreads above their borrowing cost. Let’s say for example, the government borrows for 15 years at 3.00% and then it charges 7.50% for a 15-year student loan. In this case, the government just made a 450bp revenue generating spread from issuing the loan. This makes student loans are a generous stream of revenue income for the government. The problem is that students are broke, saddled with long-term debt, and have low starting salaries all while the government is using them as an ATM. To illustrate this, let’s look at the cash flows of a current student loan.
Current Situation - Government Revenue
In Scenario 1, the current situation, the loan assumes a principal amount of $50,000, a 7.5% interest rate, and the student will make monthly payments. In this example, where the government can borrow at 3.00% and lend at 7.50%, each student loan provides a revenue generating spread of 450bps. In Figure 1, you can see the high amount of interest payments the student will be making with this loan (the blue section). The monthly payment on this loan is $463.51 and over the life of the loan, the student will have paid back $83,431 with $33,431 in total interest payments.
At Cost Loans
Scenario 2 is a hypothetical scenario where the government issues loans at cost and is no longer making income off the student. This scenario assumes a principal loan amount of $50,000, a 3.0% interest rate, and the student will make monthly payments. The overall monthly payment for this loan is $345 compared to $463 in Scenario 1; that’s a monthly savings of $118 to the student.
What is starkly different between the two scenarios, is the amount of interest savings the student obtains when the government no longer makes money off the student. The overall cost of this loan is $62,152, with $12,152 in interest payments. The difference between Scenario 1 and Scenario 2 is $21,278 in interest rate payments which would transfer from government income to an interest rate savings for the student.
Interest Rate Subsidized
Scenario 3 is a hypothetical scenario where the government issues interest rate subsidized loans. Here we’re turning the tide a bit and now the government is taking a loss on each student loan it issues. That is the same as saying the government is subsidizing higher education. In this example, the student is fully responsible for repaying all principal amount borrowed, but any interest will be fully subsidized by the government.
You can see in this interest rate subsidized scenario the student is repaying purely principal. There is no amortization because there is nothing to amortize. The total monthly payment in this case would be $278 compared to $464 in Scenario 1 and $345 in Scenario 2.
Figure 3 shows how the overall monthly payment decreases rapidly give the different interest rate scenarios. The total monthly saving in Scenario 3 is $186 compared to Scenario 1 and $68 compared to Scenario 2. The overall interest rate savings is $33,431 compared to Scenario 1 and $12,152 compared to Scenario 2.
Partial Principal Forgiveness
Lastly, Scenario 4 assumes the government forgives $20,000 of the principal loan amount. All other assumptions are the same as Scenario 1. This assumes a principal loan amount of $30,000 ($50,000 - $20,000), a 7.5% interest rate, and the student will make monthly payments. In this case, the monthly payment would be $278 with a total loan cost of $50,058; $20,058 in interest payments and $30,000 in principal payments.
What should be striking here is the similarities between Scenario 3 (the interest rate subsidized scenario) and Scenario 4 (the principal forgiveness scenario). If you look at the monthly payments between the two, they are near identical at $278. This makes sense when you consider the total amount of interest paid in Scenario 4 even after the principal forgiveness. In that example, on a $50,000 loan with $20,000 forgiveness, the student is still paying $20,000 in interest for a total loan cost of $50,000. The interest payment completely offsets any principal forgiveness. This is the exact same as taking out a loan for $50,000 and paying no intertest.
Putting It All Together
Figure 5 provides a breakdown of all the scenarios in one table. As you can see, there are a variety of ways to consider student loan debt which will provide substantially different cash flows and total costs to the student.
So, what do we do with all this information? Well, that’s up to you. I’m not trying to tell you which option is correct; I’m just trying to give you the information and you can interpret it however you want.
I would like to leave you with the understanding that currently the government is charging a high spread above the borrowing cost when issuing student loans. If we want to talk about student loan forgiveness, we might want to start by reducing the spread between the borrowing and lending cost. As we’ve seen, this will go a long way in reducing the overall student loan burden.
Thank you for reading and I hope you found this information interesting and relevant to the current topics of the day. Please feel free to reach out with any questions.
 The government doesn’t issue 15-year debt, but they do issue 10- and 20-year debt. You could always do a linear interpolation of the U.S. Treasury curve to find the 15-year rate.