The federal government offers several types of student loans to help promote access to higher education. The common goal among the different loans is to provide students with financing for higher education at better terms than those available in the private market. The main loan programs -- Stafford (both Subsidized and Unsubsidized), PLUS, Grad PLUS, and Consolidation -- are available to borrowers through one of two different administrative structures.1

Under one structure, the Federal Family Education Loan (FFEL) program, for-profit and non-profit lenders, such as Sallie Mae and ALL Student Loan, receive subsidies from the federal government for making student loans. Under the other structure, the Direct Loan program, the federal government makes the loans directly to students. Loan terms for borrowers are nearly identical under both programs. Colleges choose which program, the FFEL program or the Direct Loan program, will provide federally guaranteed loans to their students.

FFEL Program Lender Subsidies

Under the FFEL program, banks and other lenders receive two separate subsidies for making federal student loans: a guarantee against default losses and a taxpayer-subsidized, guaranteed rate of return. These two subsidies transfer much of the risk of making a FFEL loan on to the federal government. (In response to recent capital market disruptions, the Department of Education has put in place temporary programs for FFEL lenders. More information is available in a New America Foundation report

Subsidy #1: Guarantee Against Default

Lenders receive a 97 percent guarantee against default losses, which removes almost all of the default risk of the loan to the lender. If a borrower does not repay his or her federal student loan, the government pays the lender 97 percent of the outstanding principal and all of the accrued unpaid interest. In other words, the lender assumes default risk for only 3 percent of the loan principal. According to the Office of Management and Budget (OMB), payments to lenders for defaulted loans totaled $6.3 billion in fiscal year 2007. Outstanding FFEL volume totaled approximately $368 billion that year.

Subsidy #2: Guaranteed Interest Rate

Lenders are paid a subsidy, called a Special Allowance Payment, or SAP, to ensure that they receive a guaranteed interest rate on the loans. The SAP subsidy is structured so that a lender receives an interest rate payment on a federal student loan equal to a specific, variable, short term market interest rate (three-month commercial paper) plus 2.34 percentage points when the loan is in repayment and 1.74 percentage points when the borrower is attending school (these rates were recently changed for new loans).2 Borrowers make loan payments to lenders at a fixed 6.8 percent interest rate set in law (the rate is higher for PLUS loans). If the borrower interest payments are not enough to cover the lender’s guaranteed interest rate in a given financial quarter, the federal government pays the lender a SAP to make up the difference. Conversely, if the borrower interest rate payments of 6.8 percent are above the lender's guaranteed interest rate, then the lender remits the excess portion of the borrower payment to the federal government. The SAP subsidy structure effectively insulates the lender from the interest rate paid by the borrower.

The figure above illustrates the SAP subsidy structure for a Stafford loan made in the first quarter of 2007. In each financial quarter of 2007, the lender interest rate was higher than the borrower rate, triggering SAP subsidy payments to lenders. But by the first quarter of 2008, three-month commercial paper interest rates had declined, guaranteeing lenders a rate lower than the interest rate paid by borrowers, triggering a rebate from lenders to the Department of Education. According to the Office of Management and Budget (OMB), the federal government paid lenders $7.7 billion in SAP payments in fiscal year 2007. Outstanding FFEL loan volume was $368 billion in 2007.

Guaranty Agencies

In addition to private lenders, the government subsidizes 34 guaranty agencies to perform many administrative activities for the FFEL program. Guaranty agencies are state entities or private non-profit entities. The primary role of the agencies is to administer the 97 percent default guarantee on federal student loans. When a loan defaults, the guaranty agency pays the lender the federally guaranteed amount. The agency itself, however, is “re-insured” by the federal government. The Department of Education reimburses guaranty agencies for all default payments to FFEL lenders. Guaranty agencies also work to prevent loans from going into default, collect defaulted loans, and carry out other administrative roles. Each state designates one guaranty agency to administer FFEL loans originated in the state, though other guarantee agencies may also service loans in a given state.

Federal Payments to Guaranty Agencies

*Guaranty agency returns default aversion fee if a default claim is later paid on the loan.

Guaranty agencies receive a number of subsidies from the federal government for their role in the FFEL program. These include a "loan processing and issuance fee," an "account maintenance fee," and a "default aversion fee," each of which is calculated as a percentage of the loan principal. Guaranty agencies also retain 16 percent of any successful collections on defaulted loans, which represents a cost to the federal government. According to OMB, federal payments to guaranty agencies totaled $877 million in fiscal year 2007.(Click here to read more about guaranty agencies.)

Direct Loan Program Subsidies

Under the Direct Loan program, the federal government is the lender, and does not pay subsidies to private lenders or guaranty agencies. The federal government borrows funds from the U.S. Treasury and disburses the loan directly to the student at his or her school. The student repays the loan directly to the government. Although the Direct Loan program is administered in part by the U.S. Department of Education, the federal government pays private contractors to handle most of the loan servicing tasks and defaulted loan collections. Servicing contracts are awarded through a competitive bidding process, and the current private contractors that operate the Direct Loan program are the same contractors that handle servicing tasks for private lenders in the FFEL program and other financial businesses.

1. 1. Other loan programs, such as the Perkins Loan program, are made under separate administrative structures.
2. 2. Legislation enacted in late 2007 reduced the SAP subsidy premiums by 0.55 percentage points for for-profit lenders and 0.40 percentage points for non-profit lenders. The lower rates apply only to new loans issued after September 2007. All loans issued before that date continue to receive the higher subsidy rates.