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Student Loan Interest Rates Were Just Lowered. Why Does the Government Charge Interest in the First Place?

The federal government isn't a private bank, but it has reasons for charging interest on student loans.
Woman holding a bunch of money in hundred dollar bills.

There's a budgetary reason for interest rates on federal student loans.

Newly lowered interest rates on federal student loans went into effect on Monday, marking the first time interest rates have decreased in three years.

For undergraduates in the 2019 to 2020 school year, rates on direct subsidized and unsubsidized loans will fall from 5.05 percent to 4.53 percent; for graduate and professional students, rates on direct unsubsidized loans will drop from 6.6 to 6.08 percent; and for parents or graduate and professional students who pay direct PLUS loans, rates will decrease from 7.6 to 7.08 percent. The new interest rates apply to new loans issued Monday until July 1st, 2020, and last the entire life of each loan.

The federal student loan program was established through the Higher Education Act in 1965 and has always included interest, though the methods for setting rates have changed. Currently, interest rates for federal student loans are set by Congress, as opposed to private lenders who set their own (often much higher) interest rates. But why does the federal government charge interest on student loans even though it isn't a private bank?

Interest serves as a payment by the borrower to the lending institution. Since borrowing money has a value to the borrower, and lending money is expensive for the government, there is a budgetary reason for interest rates on federal student loans. In addition, if the government gave out loans without charging interest, borrowers would be incentivized to pay off loans as slowly as possible, especially as rising inflation makes them cheaper each year, explains Jason Delisle, a resident fellow at the American Enterprise Institute studying higher education financing and student loan programs.

The interest rates are designed so that borrowers pay back more than they originally borrowed. But that is often not the case for income-based repayment plans with loan forgiveness, in which people pay a percentage of their discretionary income each month over 10 to 25 years, and at the end of that period, any remaining loan balance is canceled (though borrowers must pay taxes on that amount, which includes interest).

"So even though the government says they're charging this interest rate, there are actually quite common circumstances where someone wouldn't have to pay all of that or maybe not any of it," Delisle says.

The Government Accountability Office projects that loan forgiveness programs will cost taxpayers $108 billion over the next few decades. Yet there are still nearly 45 million Americans who owe a collective $1.56 trillion in student debt.

President Donald Trump recently addressed student debt in his proposal to reform the Higher Education Act. The proposed reforms would consolidate the five income-driven repayment plans into one option and extend loan forgiveness to all undergraduate students. Many Democratic candidates for the 2020 election have also vowed to address student loan debt through their platforms. Notably, Elizabeth Warren's proposed wealth tax would alleviate debt for more than 95 percent of Americans with student loans.