Obama’s Budget and Student Loans

April 17th, 2013 / By Deborah J. Merritt

President Obama’s 2014 budget has two proposals that could affect law students who rely on federal loans. First, the President has proposed eliminating taxes on loan debts that are forgiven. Second, the proposed budget would change interest rates on student loans. Here’s more detail about both proposals, as well as an important caveat about the politics of educational loans and professional students.

Taxation of Forgiven Debt

The Department of Education offers several programs that allow law graduates to reduce their monthly debt payments. Both Income Based Repayment (IBR) and Pay as You Earn (PAYE) link repayment amounts to salary, capping payments to a percentage of the graduate’s discretionary income. The programs also forgive any remaining debt after 10 years (for graduates working in public service), 20 years (under PAYE), or 25 years (under IBR). For graduates falling in the first category, those working in public service, the value of the forgiven debt is not taxable. But for graduates in either of the other two categories, that value is taxable.

Taxation of the forgiven debt makes IBR and PAYE less attractive to graduates–especially those, like law students, who may still owe substantial amounts when their debt is forgiven. These graduates face the grim prospect of concluding one series of loan repayments only to begin a second series of structured payments to the IRS.

Obama’s proposed budget would eliminate that burdensome prospect, insulating all forgiven student debt from taxation. If adopted, the change could relieve some anxiety about student loan payments, although twenty years of repayment is still a daunting prospect.

Interest Rates

Law students qualify for two types of federal loans. First, they may borrow up to $20,500 per year in unsubsidized Stafford loans; those loans currently carry a 6.8% interest rate. Second, law students may borrow additional sums as Grad PLUS loans; the latter loans carry a 7.9% interest rate.

Both rates are quite high compared to other interest rates. The interest rate on 10-year Treasury bills has been depressed for years; it was just 1.75% earlier this week. Fifteen-year fixed-rate mortgages currently impose just 2.55% interest.

Higher rates for student loans partly reflect their increased risk; there is no collateral for an educational loan. The rates, however, also reflect the fact that Congress fixes these rates by statute rather than allowing them to shift with changes in the T-bill rate.

The President’s proposed budget would adjust interest rates on student loans by pegging them to the T-bill rate. Unsubsidized Stafford loans would charge the T-bill interest rate plus 2.93 percentage points. Grad PLUS loans would charge the T-bill rate plus 3.93 percentage points.

At current T-bill rates, this proposal would lower interest rates for law students. Interest on the unsubsidized Stafford loan would fall from 6.8% to 4.68%; interest on the Grad PLUS loan would decline from 7.9% to 5.68%. Those are both significant cuts.

As T-bill rates rise, however, so will interest rates for students. The long-term average interest rate on 10-year Treasury bills is 6.61%. At those rates, law students would pay 9.54% interest on the first $20,500 they borrowed and 10.54% on additional amounts. And that’s just the average T-bill rate; rates could move even higher.

Note that, under the Obama proposal, the interest rate for any loan would be fixed at the time of disbursal; these would not be adjustable rate loans. So, if the proposal passes, students currently enrolled in school will obtain lower-interest loans than the ones currently available; so will future students as long as T-bill rates remain low. Interest rates will rise only for students who enroll and borrow in the future, assuming that T-bill rates return to historical averages.

Politics and Professional Students

The changes outlined above are just proposals; Congress may not accept them. Both changes will cost the federal government money, at least in the short term, and there’s not a lot of money lying around on Capitol Hill. It’s too early to celebrate possible relief for students who depend on educational loans.

Professional students, in fact, face a special risk in the political debate over these proposals. Congress may decide that the President’s proposals are necessary changes for college students, but not for professional students. Professional school graduates, after all, are supposed to earn high enough salaries to repay their loans and profit handily from their educational investment; that’s what law schools and other professional schools have been telling prospective students. Why, then, should Congress spend limited funds to assist professional school graduates?

Congress, in fact, might decide to do what it has done in the past: Help college students by cutting benefits for professional ones. In the 2011 Budget Control Act, Congress eliminated subsidized loans for graduate/professional students and used that savings to improve funding for undergraduates. The upcoming debate raises the same risk: Will Congress accept the President’s proposal, which would offer benefits to current law students? Or will it worsen conditions for graduate and professional students in order to ease debt loads for undergraduates?

Hat tip to TaxProf Blog for noting these important proposals.