President Obama has suggested tying federal student loan interest rates to the market rates in his most recent budget proposal. The recommended changes would peg interest rates to the 10 year U.S. Treasury bond rate, plus a few percentage points depending on the type of loan. This would set the federal student loan interest rates each year based on the government's borrowing costs.
Under the president's proposal, interest rates for subsidized loans would be the rate for the 10-year treasury bond rate plus 0.93%, unsubsidized loans would be the 10-year rate plus 2.93%, and graduate student loans would be the 10-year rate plus 3.93%. At the current 10-year treasury note rate loan interest rates would be at 2.75%, 4.75%, and 5.75% respectively — all under the current fixed rate of 6.8% for unsubsidized and graduate student loans.
In 2012, Congress temporarily extended the 3.4% interest rates for subsidized Stafford loans; this rate is set to increase to 6.8% in July if changes are not made. Unsubsidized loans and graduate student loans remain at 6.8% the rate they have been at since 2008.
The president's proposal is similar to legislation introduced by Republican Senators Tom Coburn (R-Okla.), Richard Burr (R-N.C.) and Lamar Alexander (R-N.C.), who have introduced the Comprehensive Student Loan Protection Act which would set federal student loans at the 10 year treasury bond rate plus 3%. The 3% mark-up is to offset costs associated with defaults, collections, delinquencies or other market uncertainties. In a statement, Sen. Coburn remarked moving to a market-driven approach would "benefit both borrowers and taxpayers in the long-term," by providing certainty for student loan interest rates rather than the arbitrarily determined rates that have been made in the last few years.
Critics of tying loan interest rates to the market worry that the president's plan offers no cap-on interest rates, fearing when the economy improves interest rates would increase. Historically, Stafford loan repayment rates have included a cap between 8.25% and 9% in stronger economies. However, student borrowers have the option of the federal Income Based Repayment plan (IBR) which other borrowers, such as homeowners, do not. IBR is 15% of borrowers' discretionary income and under the terms of IBR there is a 25-year loan forgiveness and a 10-year public service loan forgiveness for remaining balances on student loans.
The Obama administration estimates that for the first five years of this plan, the change to interest rates would cost $25 billion, but would generate $14 billion in revenue for the federal government over 10 years. The president's plan would also expand repayment options that stipulate borrowers would not have to pay back more than 10% of their discretionary income and grant $1 billion in Race to the Top grants to states who find ways to cut higher education costs and limit tuition increases.