Consolidation Loans: Redesign Options and Considerations

CRS Report for Congress
Consolidation Loans:
Redesign Options and Considerations
June 8, 2004
Adam Stoll
Specialist in Social Legislation
Domestic Social Policy Division

Congressional Research Service ˜ The Library of Congress

Consolidation Loans:
Redesign Options and Considerations
Summary
This report provides background information on Federal Family Education Loan
(FFEL) program consolidation loans and discusses options for redesigning
consolidation loans. Specifically, it provides background information on the FFEL
program and on the role consolidation loans play within the program. It also
examines recent concerns voiced over the cost of consolidation loans, and discusses
the types of consolidation loan redesign options that are receiving some consideration
within the context of the reauthorization of the Higher Education Act (HEA). In
brief, the report finds the following:
^!Consolidation loans were initially introduced to simplify loan
repayment and offer borrowers relief in the form of extended
repayment. As the consolidation loan interest rate formula has been
modified by Congress, consolidation loans have evolved into a
refinance benefit as well.
^!The current consolidation loan interest rate formula affords
borrowers the opportunity to secure a fixed rate equal to the
weighted average of the rates in effect on underlying (variable rate)
loans being consolidated rounded up to the nearest one eighth of 1%.
In the recent low interest rate environment consolidation volume has
grown dramatically as borrowers have sought to lock in as
permanent the favorable rates currently in effect on their variable
loans. This has enabled a large number of borrowers to secure a
valuable refinance benefit.
^!Borrowers who lock in fixed rates through consolidation in other
periods, however, can miss out on more advantageous variable rates
that they would have had on underlying loans. This raises concerns
with regard to those using consolidation for repayment relief who
may need to consolidate in years in which the available fixed rate is
high and thus disadvantageous.
^!It is generally acknowledged that recent cohorts of low fixed rate
consolidation loans will be costly to the federal government. This
is because the government pays program lenders an interest subsidy
designed to compensate lenders for the difference between the below
market statutorily set rate charged to borrowers and fair market
compensation on the loan. The rates being provided to borrowers on
these consolidation loans, over time, are expected to be well below
market rate.
^!To gauge with precision the added subsidy cost associated with the
consolidation refinance benefit it is necessary to look beyond the
recent time period and assess comprehensively how the subsidy rates
on cohorts of loans are affected by the refinance benefit.
^!The central questions underlying the debate on the desirability of the
existing consolidation loan rate structure seem to be: How favorable
should the borrower interest rate be on a federally subsidized
refinance benefit? Is the current rate structure well suited to
accomplish policy aims?

Contents
Background ..................................................1
Rationale for Consolidation Loans............................2
Concerns About the Cost of Consolidation Loans.................4
Considering the Debate on the Fixed Rate Benefit...................10
Underlying Issues and Redesign Considerations.....................12
Consolidation Loan Design Options and Considerations..............13
Preserve the Existing Rate Structure..........................13
Eliminate the Fixed Interest Rate Benefit on Consolidation Loans...13
Offer a Refinance Benefit That Is Income Sensitive..............13
Offer a Fixed Rate Set by the Market.........................14
Offset Consolidation Costs by Capturing Floor Income...........14
Offset Consolidation Costs by Increasing Lender Fees............14
List of Tables
Table 1. FFEL Consolidation Loan Interest Rate Formulas.................4
Table 2. FFEL Stafford Loan Interest Rates.............................5
Table 3. FFEL Consolidation Loan Volume.............................6
Table 4. End of Fiscal Year 2003 FFEL Lender Held Outstanding
Consolidation Portfolio.........................................7
Table 5. Illustration of Effect of the Spread Between Lender Rates and
Borrower Rates...............................................9

Consolidation Loans:
Redesign Options and Considerations
This report provides background information on Federal Family Education Loan
(FFEL) program consolidation loans and discusses options for redesigning
consolidation loans. It also discusses the aspects of two recent reports on the cost of
consolidation loans that have garnered a good deal of attention. These reports, like
much of the recent discourse on consolidation loans, are focused on the cost of
providing a fixed interest rate on consolidation loans.
While consolidation loans are also available through the William D. Ford Direct
Loan (DL) program, recent discussion of consolidation loans has largely centered on
FFEL program consolidation loans. For this reason, FFEL consolidation loans will
be the focus of this report.
This report is organized in the following manner. First it provides background
information on the FFEL program and on consolidation loans. Then it discusses
recent concerns voiced over the cost of consolidation loans. Next it examines two
reports addressing this issue, and the report concludes with a brief discussion of
consolidation loan redesign options and considerations.
The report discusses issues that are currently being considered within the
context of Higher Education Act (HEA) reauthorization activities. It will not be
updated.¹
Background
The Federal Family Education Loan program, authorized by Part B of Title IV
of the HEA, provides loans to undergraduate and graduate students and the parents
of undergraduate students to help them meet the costs of postsecondary education.
Under the FFEL program, loan capital is provided by private lenders, and the federal
government guarantees lenders against loss through borrower default, death,²
permanent disability, or, in limited instances, bankruptcy. The federal government
also provides lenders with a loan subsidy known as a special allowance payment

¹ An earlier version of this report was published on May 26, 2004 as a Congressional
Distribution Memorandum. It is being published in report form to more easily facilitate
broad Congressional access.
² For detailed information on the array of FFEL program loans, see CRS Report RL30655,
Federal Student Loans: Terms and Conditions for Borrowers, by Adam Stoll. For a
thorough discussion on how the loan program operates, see CRS Report RL30656, The
Administration of Federal Student Loan Programs: Background and Provisions, by Adam
Stoll.

(SAP). The SAP amount is determined on a quarterly basis by a statutory formula
which is tied to a financial index and ensures lenders receive, at a minimum, a
specified level of interest income on loans. The SAP is designed to compensate
lenders for the difference between the below-market, statutorily set interest rate
charged to borrowers and a market set interest rate that is intended as fair market
compensation on the loan asset.
The FFEL program provides the following types of loans to students and their
parents:
Stafford loans (subsidized and unsubsidized): Low interest, variable rate loans
available to undergraduate and graduate students. The interest rates on
subsidized and unsubsidized Stafford loans adjust annually, based on a statutorily
established market-indexed rate setting formula, and may not exceed 8.25%.
To qualify for a subsidized Stafford loan, a student must establish financial need.
The federal government pays the interest on the borrower’s behalf on the
subsidized Stafford loans while in school (on at least a half-time basis) and
during grace periods and deferment periods.
PLUS loans: Variable rate loans available to parents of dependent undergraduate
students. The interest rates on these loans adjust annually, based on a statutorily
established, market-indexed rate-setting formula, and may not exceed 9%.
Consolidation loans: Loans that provide borrowers refinancing options.
Consolidation loans enable borrowers to simplify the repayment of loans by
combining multiple loans into one. Consolidation loans also enable borrowers
to lower monthly payments by extending the repayment period. Additionally,
consolidation loans afford borrowers the opportunity to pursue a more favorable
long tem interest rate through locking in a fixed interest rate on their student
loans, based on the weighted average of the interest rates in effect on the loans
being consolidated rounded up to the nearest one-eighth of 1%, capped at³

8.25%.

Rationale for Consolidation Loans. Consolidation loans were introduced
in the HEA Amendments of 1986 (P.L. 99-498). They were initially introduced to
simplify repayment for borrowers, simplify loan repayment servicing for lenders, and
to offer relief in the form of extended repayment to those borrowers seeking lower
monthly payments.
Table 1 depicts the various interest rate formulas that have been used to set rates
on consolidation loans. As Table 1 shows, the consolidation loan benefit has
evolved into much more of a refinance benefit (i.e., a benefit that allows borrowers
to refinance at a better rate) as the consolidation loan interest rate formula has been
modified by Congress.

³ For a comprehensive description of consolidation loans’ terms and conditions, see CRS
Report RL31575, Consolidation Loan Provisions in the Federal Family Education Loan and
Direct Loan Programs, by Adam Stoll.

Under the initial consolidation loan interest formula (see Table 1), the borrower
rate was fixed at the weighted average of the loans being consolidated, with a
minimum rate of 9%. For student borrowers, this meant the rate on a consolidation
loan would be equal to or higher than the rates on the loans being consolidated.
The second FFEL consolidation loan rate setting formula offered borrowers the
possibility of securing a better rate through consolidation. At the time this
consolidation loan interest rate formula was in effect, Stafford rates were variable.
Through consolidation a borrower could lock in as permanent favorable annual rates
in effect on their variable rate loans (rounded up to the nearest whole percent).
Furthermore, toward the end of the period in which this formula was in effect, a
Stafford grace period interest rate was enacted, and consolidation borrowers were
afforded the opportunity to lock in as permanent their grace period rate (which is
lower than the repayment period rate).⁴
The third consolidation loan interest formula was the same variable rate formula
available on Stafford loans.
The most recently enacted formula, which is currently in effect, offers borrowers
the strongest opportunity to refinance at a better rate through consolidation. It
enables borrowers to lock in as permanent favorable annual rates in effect on their
variable rate loans (rounded up to the nearest one-eighth of 1%). Additionally, it
affords borrowers the opportunity to lock in as permanent their grace period rate.

⁴ The grace period is a six-month period immediately following a student’s departure from
school. A lower rate is provided during the grace period because loan servicing costs are
lower during this period in which no borrower payments are required. Grace period rates
are .60 percentage points lower than repayment rates.

Table 1. FFEL Consolidation Loan Interest Rate Formulas
FFEL consolidation loan interest rate
Disbursement periodType of rateformula in effect
October 17, 1986-FixedThe greater of 9% or the weighted average of
June 30, 1994interest rates on the loans consolidated,
rounded to the nearest whole percent.
July 1, 1994 -FixedThe weighted average of interest rates on the
November 12, 1997loans consolidated, rounded upward to the
nearest whole percent.
November 13, 1997 -Variable91-day Treasury bill + 3.1%, capped at
September 30, 19988.25%
October 1, 1998 -FixedThe weighted average of interest rates on the
presentloans consolidated, rounded to the nearest
higher one-eighth of 1%, capped at 8.25%.
^Source:^Hⁱ^g^h^e^{r Edu}^catⁱ^oⁿ^A^c^t^,^S^ectⁱ^oⁿ^s^427A^{(20 U}^.^S^.^C^.^{§ 1077a)}^an^d^428C⁽²⁰^U^.^S^.^C^.^§^1078-^3).
Concerns About the Cost of Consolidation Loans. The recent discourse
on consolidation loans has centered on the desirability of preserving the existing
fixed interest rate formula. Concerns about the cost of preserving the existing fixed
rate benefit have surfaced in light of the prevailing rates on variable rate Stafford
loans. Stafford loans, which are the primary “underlying loans” incorporated into
consolidation loans, carry a variable rate that adjusts annually and is determined by
a statutory rate-setting formula. The borrower rate on Stafford loans has been quite
low in recent years. Consolidation loans afford Stafford borrowers a refinance
mechanism enabling them to lock in low rates permanently. When borrowers
exercise this option the federal government is potentially exposed to high subsidy
costs because the government has guaranteed the lenders a market rate of return, and
must make up the difference between the rate the borrower is paying and the rate the
lender is guaranteed (i.e., the SAP).
As one might expect, federal consolidation loans have become increasingly
popular in the recent low interest rate environment. Most of the underlying loans
being consolidated are variable rate Stafford loans offering historically low annual
rates which can be locked in permanently through consolidation. As the shaded area
in Table 2 shows, the rates on Stafford loans in the last two years have been quite
low.

CRS-5
Table 2. FFEL Stafford Loan Interest Rates
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Not surprisingly, FFEL program consolidation volume has nearly quadrupled
in recent years, going from approximately $8.3 billion in award year (AY) 2000-2001
to an estimated $31.1 billion in AY2003-AY2004. Table 3 shows recent trends in
FFEL consolidation volume. Of particular interest is the growth in volume over the
last couple of years which shows the effects of the low rates on Stafford loans.
Table 3. FFEL Consolidation Loan Volume
Award yearConsolidation loan volume
1993-1994 1,817,000,000
1994-1995 2,948,000,000
1995-1996 3,980,000,000
1996-1997 4,049,000,000
1997-1998 3,460,000,000
1998-1999 4,495,000,000
1999-2000 5,653,000,000
2000-2001 8,261,000,000
2001-2002 16,953,000,000
2002-2003 32,290,000,000
2003-2004^a 31,114,000,000
^Source:^F^Y^{2005 Pres}ⁱ^d^en^t^’^s^Bu^dg^et^.
^{a. L}^o^an^v^o^l^u^m^eⁱ^s^proj^ect^{ed f}^o^{r A}^Y^2003-^{2004, w}^hⁱ^c^h^s^p^an^s^Ju^l^y^{1, 2003-}^Juⁿ^e^{30, 2004 an}^{d i}^sⁿ^o^t
^y^e^{t co}^m^p^leted^.
Table 4 displays the effect of the recent spike in consolidation volume on the
composition of the outstanding portfolio of consolidation loans through the end of
FY2003. It has led to a growing concentration of consolidation loans with low fixed
interest rates. As Table 4 reveals, at the end of FY2003 more than 44% of
outstanding consolidation loans had fixed interest rates of 5% or below. It should be
noted that much of the consolidation volume projected for AY2003-AY2004 (see
Table 3) is not captured in the FY2003 data. Due to this and projections calling for
low rates in AY2004-AY2005, low interest rate fixed loans are expected to constitute
a considerably larger share of the outstanding portfolio in upcoming years.
That said, it is also noteworthy that at present, roughly one quarter of all
outstanding consolidation loans have relatively high fixed interest rates — above
7.75%. Roughly 18% have fixed rates at or above 8.25%. These loans are likely to
be less costly to the government than they would have been had they retained their
variable rate.

This also introduces a facet of the fixed rate benefit some find troubling — some
borrowers fare worse under the high fixed rate they lock in than they would have had
they retained their variable rate. This raises concern, particularly with regard to those
using consolidation for repayment relief (i.e., extended repayment), because these
borrowers may have to consolidate in years in which the fixed rate is
disadvantageous.
Table 4. End of Fiscal Year 2003 FFEL Lender Held
Outstanding Consolidation Portfolio^a
Percent of total
Interest rate range^bVolume outstandingportfolio

3.5 and below6,305,947,0057.98%

3.51 - 3.754,033,058,9025.10%

3.76 - 4.02,881,137,6083.65%

4.01 - 4.258,108,619,89610.26%

4.26 - 4.54,612,711,7515.84%

4.51 - 4.753,084,520,9943.90%

4.76 - 5.06,062,160,3057.67%

5.01 - 5.251,056,901,0871.34%

5.26 - 5.5275,988,1710.35%

5.51 - 5.752,169,920,1752.75%

5.76 - 6.01,839,704,0892.33%

6.01 - 6.252,259,302,8712.86%

6.26 - 6.52,779,265,6353.52%

6.51 - 6.752,942,535,0013.72%

6.76 - 7.04,134,495,7105.23%

7.01 - 7.25863,937,0571.09%

7.26 - 7.51,424,129,0061.80%

7.51 - 7.752,783,575,1813.52%

7.76 - 8.05,051,613,2706.39%

8.01 - 8.24781,479,2810.99%

8.25 6,591,059,219 8.34%

8.26 and above7,332,472,7259.28%

FY2003 variable rate1,642,549,6072.08%
consolidation loans 4.22
Totals 79,017,084,546 100%
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It is generally acknowledged that the recent cohorts of consolidation loans will
be costly to the federal government. This point is easily illustrated by examining the
key determinant of the interest subsidy cost — the spread between the lender rate⁵
and the borrower rate. Two scenarios presented in Table 5 examine this relationship.
Both of the scenarios presented in Table 5 assume that a borrower chooses to
consolidate outstanding Stafford loans (all of which have been disbursed since July
1, 1998) and repay the consolidation loan over a 10-year repayment term.⁶ Under the
first scenario examined in Table 5 it is assumed the borrower consolidates loans in
the current year while still in the grace period and secures a fixed interest rate of
2.88% on a consolidation loan. This is the most favorable rate scenario that has been
available to borrowers who have borrowed since the current Stafford rate setting
formula has been in effect.
Under the second scenario, the borrower consolidates loans early in July 2000
securing a fixed interest rate of 8.25% on a consolidation loan. This is the least
favorable rate scenario that has been available since the current Stafford rate setting
formula has been in effect.
These two scenarios present boundaries within which most recent consolidations
fall. However, as the data in Tables 3 and 4 suggest, recent consolidations have
been much more likely to resemble the first scenario (projected consolidation volume
for that year is nearly four times as large as the year in which the second scenario’s
consolidation occurred).
For each scenario, a spread between the lender rate and borrower rate on
consolidation loans is provided. For comparative purposes, another spread —
between the lender rate and a variable Stafford borrower rate is provided. The two
spreads presented for each scenario illustrate the potential additional cost associated
with providing the fixed rate benefit. In other words, they allow for a comparison of
how the lender rate relates to a locked-in fixed rate or a variable Stafford rate that the
borrower could have chosen to retain.
For each of the examples, the lender rates were constructed by using actual
Commercial Paper (CP) rates where available for past periods (if applicable) and the
Congressional Budget Office’s (CBO’s) projected CP rates for future periods. The
variable borrower rates were constructed by using actual loan interest rates where
available for past periods and CBO’s projected T-bill rates for future periods.⁷ Since
the lender rates are being presented to illustrate the interest subsidy on consolidation

⁵ For the purposes of this memorandum the lender rate is the Commercial Paper based
component of the SAP calculation net of the payment lenders make back to the government
on consolidation loans.
⁶ A 10-year repayment term has been chosen to allow for easy comparisons between interest
subsidies on a new consolidation loan as opposed to the underlying loans had they not been
consolidated.
⁷ Projections of bond equivalent rates of 91-day Treasury bill rates and three-month
Commercial Paper rates from CBO’s Mar. 2004 baseline projections for student loan
programs have been used to calculate borrower and lender rates for future years.

loans they are adjusted downward for the annual 1.05% fee lenders pay the
government on consolidation loans.
Table 5. Illustration of Effect of the Spread
Between Lender Rates and Borrower Rates
Scenario 1: borrower consolidating atScenario 2: borrower consolidating at
2.88% fixed rate8.25% fixed rate
Estimated annualized lender rate = 6.49 Estimated annualized lender rate = 5.21
Borrower rate = 2.88Borrower rate = 8.25
Estimated annualized SAP rate = 3.72^aEstimated annualized SAP rate = 0^a
If the loan remained a variable rateIf the loan remained a variable rate
Stafford loanStafford loan
Estimated annualized lender rate = 7.23Estimated annualized lender rate = 5.95
Estimated borrower rate = 5.93^bEstimated borrower rate = 5.63^b
Estimated annualized SAP rate = .80^aEstimated annualized SAP rate = .78^a
^Source:^C^R^S^es^tim^ates^.
^No^te:^T^h^e^e^s^tⁱ^m^a^t^e^d^a^nnua^lⁱ^z^e^d^l^e^nd^e^r^r^a^t^e^{s a}ⁿ^d^SA^P^r^a^t^e^sⁱⁿ^Ta^ble⁵^{are of}^f^e^{red as}^approxⁱ^m^atⁱ^oⁿ^s^.
^Du^{e to}^lim^itatioⁿ^sⁱⁿ^th^{e d}^a^{ta u}^p^oⁿ^w^h^ich^th^{ese calcu}^latioⁿ^s^ar^e^b^a^sed^,^th^ey^sh^o^u^ldⁿ^o^{t b}^e^vⁱ^ew^ed^as
^preci^s^e^proj^ectⁱ^oⁿ^s^.
^a^.^Le^nd^e^r^r^a^t^e^{s ha}^ve^b^e^eⁿ^c^o^nst^r^uc^t^e^d^t^h^r^o^{ugh t}^h^e^use^o^f^a^c^t^ua^l^t^h^r^e^e^-^m^o^nt^{h CP}^r^a^t^e^{s w}^h^e^r^e
^applⁱ^cabl^e^an^{d C}^B^O^proj^ectⁱ^oⁿ^s^of^C^P^rat^e^s^f^o^{r f}^u^t^u^{re peri}^ods^{. F}^o^{r pas}^t^peri^ods^{, t}^h^e^l^eⁿ^d^{er rat}^e
^is^bas^e^{d on}^an^av^erag^{e of}^qu^arterly^C^P^rates^u^s^{ed in}^actu^a^{l SA}^P^calcu^lation^s^plu^s^an^{add on}⁸
^(1.59^f^o^r^coⁿ^s^o^lid^atioⁿ^lo^an^{s an}^d²^.³⁴^f^o^r^Staf^f^o^r^d^loan^s⁾^{. For f}^u^tu^{re y}^ears^,^len^d^{er rates}^are
^con^s^t^r^u^c^t^e^{d bas}^e^{d up}^oⁿ^CB^O^’^s^aⁿⁿ^u^a^l^C^P^rat^e^proj^ectⁱ^oⁿ^s^pl^u^s^an^{add on}^{. T}^o^con^s^t^r^u^c^t^t^h^e
^e^s^tⁱ^m^a^t^e^d^a^nnua^lⁱ^z^e^d^SA^P^r^a^t^e^t^h^e^a^nnua^l^b^o^r^r^o^w^e^r^r^a^t^eⁱ^s^sub^t^r^a^c^t^e^d^fr^o^m^t^h^e^a^nnua^l^l^e^nd^e^r^r^a^t^e
^an^d^th^en^th^e^dⁱ^f^f^e^r^eⁿ^c^e^s⁽^w^ithⁿ^e^g^a^tiv^{e v}^a^lu^es^{treated as}^zeroes⁾^av^erag^{ed acros}^s^{all relev}^aⁿ^t
^y^ears^.
^b^.^T^h^e^va^rⁱ^a^b^l^e^r^a^t^e^b^o^r^r^o^w^e^rⁱⁿ^t^e^r^e^st^r^a^t^e^{s a}^r^e^p^r^e^s^eⁿ^t^e^dⁱⁿ^A^P^{R fo}^r^m^.^A^P^{R i}^s^t^h^e^e^s^tⁱ^m^a^t^e^d^a^nnua^l
^p^e^r^cen^tag^e^r^a^{te p}^a^id^uⁿ^d^er^th^{e v}^a^rⁱ^ab^{le r}^a^{te f}^o^r^m^u^l^a.
The 2.88% consolidation loan in the first scenario illustrates the type of spread
that has generated concern over the cost associated with the fixed interest benefit.
Under this scenario, the estimated rate for lenders is well above the borrower rate,
meaning the federal government has a large difference to make up. As the estimated
SAP rate suggests, under this scenario the government may end up paying more
interest on the loan than the borrower does.
By looking at the relationship between the borrower — lender rate spread on the
fixed rate consolidation loan compared to the spread had the loan remained a Stafford
loan one gets a sense of the additional cost to the federal government associated with
the fixed rate benefit. The loan has been transformed from a below market rate to a

⁸ The 1.59 add-on reflects the actual 2.64 add-on minus the 1.05 basis point annual fee.

well below market rate for the borrower, but has a high subsidy cost for the federal
government.
The second scenario illustrates a situation in which the government may have
no SAP related subsidy cost under consolidation loans. The borrower is already
paying more than the rate the government guarantees lenders when it calculates and
pays SAPs, so no SAP is necessary. The amount of income lenders receive above the
government rate is often called floor income (discussed more later).
Additionally, the estimated SAP rate of zero on the fixed rate consolidation loan
is less than the estimated SAP rate applicable had the loan retained its Stafford
variable rate. This illustrates the savings to the federal government as well as the
relatively high costs to borrowers, associated with the fixed rate benefit on loans
refinanced at a high fixed rate.
Considering the Debate on the Fixed Rate Benefit
Contrasting conclusions have been reached in two recently released high profile
reports on the cost of providing a fixed interest rate on consolidation loans. In the
text below an attempt is made to examine why the reports reach dissimilar
conclusions.
The first such study is The Net Incremental Cash Flow and Budget Effects of the
FFEL Consolidation Loan Program, FY2005-FY2010, by Ernst and Young. This
study examines the budgetary effects of FFEL Consolidation loans by studying
historical cash flows in the FFEL consolidation loan program to and from the federal
government within a discrete time period (fiscal years 1995-2002) and by estimating
the net present value of future cash flows for certain cohorts of consolidation loans.
The study primarily profiles positive historical cash flows for the federal government
on consolidation loans and projected positive budgetary effects for future cohorts of
consolidation loans. It does, however, find that two recent cohorts of consolidation
loans have substantial federal interest subsidy costs.
The Ernst and Young study suggests that in the recent historical time period
examined consolidation loans have produced a positive net cash flow for the federal
government. Because the study does not attempt to capture lifetime costs associated
with the consolidation loans examined here, these findings are of limited value.
Given the influence rate fluctuations across time periods have on the cost of
subsidizing loans, there is no reason to believe that a chosen discrete time period will
be reflective of costs over the life of a loan. For this reason, it is common to gauge
the lifetime cost of credit, and not to isolate particular time periods for analysis.
The Ernst and Young study presents estimates of the budget effect of future cash
flows of the recent large cohorts of consolidation loans (i.e., those made in fiscal
years 2003 and 2004) in the period from FY2005-FY2010. These consolidation
loans are estimated to add $3.5 billion in federal interest subsidy cost in that time
period. These findings are adversely affected by the timing of the study. The
FY2004 cohort is much larger than was projected at the time, and interest rates are
lower than projected, meaning the subsidy cost for these loans is likely
underestimated.

The study presents projections of the net present value of lifetime costs of future
cohorts of consolidation loans — those disbursed from FY2005-FY2010. This part
of the study focuses on the lifetime cost of consolidation loans over and above the
interest subsidy on the underlying loans. The Ernst and Young study projects these
consolidations to have positive budgetary effect for the government. The net present
value of the incremental cash flow from these consolidation loans is projected to be
$1.9 billion. The long term projections assume a 6.8% fixed borrower rate takes
effect for new Stafford loans as of July 2006. This is a reasonable assumption (based
on existing statutory provisions) but does not address the difference between a fixed
and variable rate. It should be noted that several projections were updated by Ernst
and Young for its March 17, 2004 congressional testimony, however, insufficient
details were available to enable the updated information to be considered here.⁹
The second study is The Fiscal and Social Costs of Consolidating Student Loans
at Fixed Interest Rates, by Kevin Hassett and Robert Shapiro. This study examines
the budgetary effects of FFEL consolidation loans by studying the projected lifetime
costs of outstanding consolidation loans. It concludes, based upon a series of
modeling assumptions that the lifetime cost of subsidizing all outstanding
consolidation loans may range from $14 billion to $48 billion. It is important to note,
however, that the study is focused on consolidation loans’ “total” subsidy cost as
opposed to the “additive” subsidy cost associated with the fixed rate benefit. In other
words, underlying loans (e.g., unsubsidized Stafford loans) already carry an interest
subsidy — the key question in the eyes of many observers, though unanswered in this
report, is: How much more expensive do they become when they are converted to
fixed rate loans?
Additionally, the methodology Hasset and Shapiro used for arriving at budgetary
cost approaches the issue analytically at a very high level of aggregation.
Characteristics taken from across the entire portfolio of outstanding consolidation
loans (i.e., mean values for interest rates and repayment terms) are used to model
costs for the entire portfolio. This approach lacks the precision that would be derived
from assessing costs of each outstanding cohort of consolidation loans.
The Hasset and Shapiro cost projections are also reliant upon their own
forecasting of CP rates over the next 20 years. All rate projections, and especially
long term rate projections, contain some real degree of imprecision.¹⁰
Each of these studies has limitations. What would be needed to gauge added
cost with more precision are analyses that comprehensively assess costs associated
with providing the fixed rate refinance benefit across the varied cohorts of

⁹ Testimony of Dr. Thomas S. Newbig, Ernst and Young, for U.S. Congress, House
Committee on Education and the Workforce, Fiscal Responsibility and Federal
Consolidation Loans: Examining Cost Implications for Taxpayers, Students, and^th^nd
Borrowers, 108 Congress, 2 sess., Mar. 17, 2004.
¹⁰ A recent CBO analysis of its own forecast record and that of OMB and the Blue Chip
consensus finds that the difference between two-year forecasts and actual outcomes over the
past 20 years was one percentage point or more for each entity. It is reasonable to assume
that longer term projections would be less precise.

outstanding Stafford loans. The subsidy rate on Stafford loans is affected by the
available refinance benefit. It would be helpful to examine the way in which these
subsidy rates are affected by fixed rate and/or alternative refinance benefits.
Underlying Issues and Redesign Considerations
Several issues underlie the debate on consolidation loan interest rates.
However, the debate seems to be centrally focused on the following issues:
^!How favorable should the borrower interest rate be on a federally
subsidized refinance benefit?
^!Is it desirable to offer the current fixed rate option on consolidation
loans?
Those in favor of the existing fixed rate setting formula assert that in the current
low interest rate environment the fixed rate amounts to a valuable benefit to
borrowers. At a time of escalating student loan debt it provides important repayment
relief and sends a signal to students and potential students that repayment will be
manageable. Further, proponents of the existing rate setting formula suggest that
eliminating the opportunity to lock in a fixed rate would be tantamount to taking
away a benefit that was available when borrowers received their Stafford loans and
that they are counting on utilizing once they enter repayment. The removal of this
benefit in today’s interest environment would amount to dropping roughly half the
interest subsidy currently available to borrowers.
Proponents of offering a fixed rate on consolidation loans suggest it provides
borrowers with a level of certainty about their repayment amount which is not
available through the variable rate. They also suggest it is optimal to allow
borrowers a choice between fixed and variable rate options.
Those opposed to sustaining the existing rate setting formula suggest it offers
an overly generous borrower benefit that is costly to the point of placing future aid
in jeopardy. Further they question whether a benefit received in the years after
postsecondary schooling contributes in any way to students’ postsecondary access,
persistence, or choice. They note the repayment period subsidy is provided without
regard to need, over a lengthy period potentially extending up to 30 years beyond
schooling, and disproportionately benefits students who attended four-year private
institutions and/or graduate programs.
Opponents of offering a fixed rate option suggest such an option is inherently
flawed if it bears no relationship to loan financing or subsidy costs, and argue it
results in cost to either the federal government or the borrower. If the borrower locks
in a low fixed rate, federal subsidy costs escalate. If the borrower locks in a high
fixed rate, the borrower pays an above market rate over the life of the loan. Further,
they suggest the variable rate formula (with a cap) provides borrowers with
protection from exceedingly high rates, and reduces risk for the borrower and the
government.

Consolidation Loan Design Options and Considerations
This report concludes with a brief discussion on consolidation loan design
options and considerations. As a backdrop to this discussion it is important to
consider the structure of existing subsidies. In the text that follows several options
for setting the rate on consolidation loans are considered. The discussion is limited
to some of the major options having received attention in the recent debate. In
general the policy discourse has been centered on the desirability of offering a fixed
versus a variable rate on consolidation loans. CRS, of course, takes no position on
any option presented.
The interest subsidies supporting Stafford borrowers can be divided into three
categories: (1) The need-based interest benefit on subsidized Stafford loans through
which the government pays the borrower’s interest during periods in school, grace,
or deferment; (2) The SAP on all Stafford loans which guarantees a borrower rate
based upon a statutory rate setting formula with an interest cap — designed to be a
below market rate; and (3) The SAP on consolidation loans which offers the
borrower an opportunity to lock in an even better rate. It is this last category of
subsidy that is under debate.
Possible options include:
Preserve the Existing Rate Structure.¹¹ Under this approach the
additional interest subsidy would remain available to borrowers who consolidate in
a low interest rate environment. Borrowers who consolidate in a high interest rate
environment (e.g., those who are consolidating due to a need to extend their
repayment period in order to reduce monthly payments) would likely pay a higher
rate on their consolidation loan than they would have on a Stafford loan. Concerns
about added federal subsidy costs associated with future high volume consolidation
periods when interest rates are low would not be alleviated.
Eliminate the Fixed Interest Rate Benefit on Consolidation Loans.
Under this approach borrowers would retain their Stafford interest rate and receive
no additional interest subsidy when they consolidate. Consolidation would cease to
offer an additional interest benefit, but would retain its role in simplifying repayment
and providing extended repayment. Concerns about added federal subsidy costs
associated with consolidation would be alleviated, and federal subsidy costs may be
reduced, but borrowers would lose a potential benefit they now enjoy.
Offer a Refinance Benefit That Is Income Sensitive. Under this
conceptual approach borrowers could still be offered a more generous interest
subsidy on a refinanced loan, but the additional interest subsidy would be offered on
a selective basis contingent upon need. Depending on how such a benefit were
structured it could reduce federal subsidy costs by conferring subsidies on fewer
recipients over shorter intervals. It could also bestow heavier subsidies than are

¹¹ This discussion on this option and subsequent options assumes that Stafford loan interest
rates are variable.

currently available during periods of need (which could reduce or eliminate savings
in subsidy costs).
Offer a Fixed Rate Set by the Market. Under this approach borrowers
could choose to retain their Stafford variable interest rate and would receive no
additional interest subsidy when they consolidate. For borrowers making this choice,
consolidation would offer no additional interest benefit, but would retain its role in
providing relief in the form of extended repayment. Alternatively, those borrowers
seeking a certain monthly payment could choose to select a fixed rate set by lenders
(presumably on a loan that would cease to carry a SAP). Under this scenario the
fixed rate would likely cost the borrower more (which would be reflective of the
loan’s higher finance costs), but the fixed and variable rate options would be
available. This would provide borrowers fixed and variable rate options, and may be
cost neutral to the federal government.
Offset Consolidation Costs by Capturing Floor Income. Under most
of the approaches discussed above federal interest subsidies could be reduced by
having lenders’ floor income on consolidation loans refunded to the federal
government. The floor income is income lenders earn in quarters when the borrower
rate is above the SAP rate (which is designed to approximate fair market interest
income for lenders).
Offset Consolidation Costs by Increasing Lender Fees. It may be
possible to reduce federal subsidy costs associated with any of the rate structures
proposed above by increasing lender fees on consolidation loans. If lender fees can
be increased without jeopardizing lender participation in the consolidation loan
program, this is another option.