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The Congressional Budget Office (CBO) estimates and reports annually the cost of new federal student loans that are expected to be made in the current and future years. The Office of Management and Budget also reports estimated costs in the president's budget request to Congress each year. Rules in the Federal Credit Reform Act govern how budget agencies estimate and present loan costs. However, the CBO and other budget experts argue that those rules systemically understate costs and fair-value estimates are more comprehensive (see below). In the most basic terms, cost estimates for federal student loans under either accounting method include two components: subsidy rates and loan volume.

How Loan Costs are Calculated

Budget agencies estimate student loan costs by first determining the average subsidy rate for all types of federal student loans. The subsidy rate represents the lifetime cost of the loan to the federal government, calculated to account for the time value of money, in the year the loan is made. The subsidy rates are intended to reflect such costs as the below-market interest rates charged to borrowers, loan forgiveness programs, and the expected losses the government might incur when borrowers fail to repay loans. The subsidy rates for the loans are presented as a percentage of the value of all the underlying loans that will be made. Most of the administrative costs that the federal government incurs for the loan programs are excluded from the subsidy amounts, a practice required by cost estimate rules.

The subsidy rate is then applied to the total volume of loans that will be originated in a given year to calculate the total cost of the loan program in a given fiscal year. Both CBO and OMB must estimate the number and value of loans that are likely to be originated in a future year. The agencies can then determine the total federal cost by multiplying the subsidy rate by the total value of the loans that will be made. The table below details the average subsidy rates, total loan volume, and total loan costs estimated for loans expected to be made in 2013 as reported by CBO.

Federal Student Loan Volume and Subsidy Cost Estimates, Fiscal Year 2014
Loan Type Subsidy Rate New Volume Cost
Subsidized Stafford -1.9% $28.1 billion -$0.5 billion
Unsubsidized Stafford -20.1% $60.5 -$12.2
Grad PLUS -44.3% $9.3 -$4.1
Parent PLUS -41.1% $10.9 -$4.5
Total -19.6% $108.9 -$21.3
Source: Congressional Budget Office 2013 Baseline, Updated for P.L 113-28

Federal Budget Treats Loans Differently

Estimating and reporting the cost of federal loan programs presents a challenge. When the federal government spends money or policymakers propose a new program, the costs appear in the budget or cost estimates on a "cash basis." This means that if $100 million will be spent this fiscal year on a particular program, the cost is reflected in the federal budget as $100 million this year. It is difficult, however, to measure the cost of a government loan program in such a manner because a cash basis represents only a snapshot in time. That is, it does not reflect the cost of loans that in many cases will be repaid over decades. To make cost estimates for loan programs more meaningful, budget analysts report the costs of federal loan programs on a net present value basis in accordance with rules enacted in the Federal Credit Reform Act of 1990. Under this approach, the lifetime cost of a student loan is shown in the year that the loan is made. All future costs and interest repayments associated with the loan are discounted to the present using interest rates on U.S. Treasury debt with a duration that matches the underlying loan.

Why Treat Loans Differently?

Prior to enactment of the Federal Credit Reform Act in 1990, student loan costs were reported in the budget on a cash basis, just like all other federal programs, and the effects were misleading. For example, loans provided by private lenders with federal guarantees against default or interest rate risk appeared to have no cost until the borrower defaulted. (Until 2010, most federal student loans were made through the Federal Family Loan Program, which provided guarantees to private lenders making student loans at terms set in law.) In other words, making a student loan through a guarantee cost nothing when the loan was made even though the government took on binding risks that could result in costs in the future. Recording costs on a cash basis when the government lent directly was also misleading. On a cash basis, when the government provided a loan directly, as is done under the Direct Loan program, the loan principal was treated as a grant the year that it was made. When the borrower later paid it back principal and interest, the funds were treated as receipts, appearing as positive cash flow in that year.

The examples below illustrate how cash budgeting provides misleading cost information and how net present value budgeting provides a more meaningful estimate of the cost of making a loan.

Consider how costs are recorded under cash budgeting for a $3,000 Subsidized Stafford student loan provided as a direct loan. In the year that the loan is made, costs for making the loan directly from the federal Treasury costs $2,955. Note that these costs reflect only the first year of the loan. (Examples are taken from the 2005 Congressional Budget Office paper "Subsidy Estimates for Guaranteed and Direct Student Loans," Appendix A.)

Cash Budgeting: First Year Cost of a $3,000 Direct Student Loan
10-Year Loan to Student $3,000
Principal Disbursement $3,000
Fees (net) -$45
Repaid principal and interest $0
Cost to government $2,995

Now consider the same loan, but under net present value budgeting – the approach that is used to record student loan costs in the federal budget. Discounting the full 10-year costs associated with the loan to the year in which the loan is made results in a much different cost than when a cash budgeting approach is used. The loan costs negative $66.

Net Present Value Budgeting: First Year Cost of a $3,000 Direct Student Loan
10-Year Loan to Student $3,000
Principal Disbursement $3,000
Fees (net) -$45
Repaid principal and interest -$3,021
Cost to government -$66

Current Budget Rules Understate Costs

The Congressional Budget Office and other experts argue that while the Federal Credit Reform Act of 1990 improved how the federal government reports the cost of loan programs, it includes a provision that systematically understates the costs of loan programs. Another Congressional Budget Office report on this topic can be found here.

Specifically, the law requires that budget analysts calculate the net present value of a federal loan using a discount rate that matches the government’s cost of borrowing. That is, once an agency has estimated the expected performance of a loan over its entire duration, it must translate that performance into a present value using the risk-free interest rate on U.S. Treasury debt. Experts argue that agencies should discount loan performance using a rate that reflects the riskiness of the loan performance itself, not the interest rate on U.S. Treasury debt, which by definition bears no relation to the risk taxpayers are exposed to when the government makes a loan. Using a risk-adjusted discount rate calculates the “fair value” of the government loan.

In a 2010 report, the Congressional Budget Office calculated the fair-value cost of an average federal student loan and found that over the subsequent ten years, the loans will be made at a 12 percent subsidy. In other words, the government will subsidize students at a rate of $12 for every $100 they borrow. A subsequent estimate done in 2013 projected that the average subsidy over the next 11 years would average 7 percent.

The Congressional Budget Office has published three fair-value subsidy estimates (the 2007 estimate is from a working paper and is not official). The subsidy rates are for each cohort of loans issued in the year shown, by estimate, and reflect the cost of the loan over its entire duration. For example, loans issued under the 2008 cohort had an estimated fair-value subsidy rate of 29.5%, according to the 2007 estimate. According to the 2013 estimate, loans issued in 2014 will be made at a fair-value subsidy rate of -3.7%, and loans issued in 2017 will be made at a fair-value subsidy rate of 9.1%.
Source: Congressional Budget Office; New America Foundation
Published Sep 4 2013 18:23