Should Student Loans Have Interest Rates At All?
April 7, 2015

Given the ever-increasing student loan crisis, the measures taken by the federal government suggest that they haven’t yet zeroed in on the root cause. Many solutions proposed by the goverment seem to pull in opposing directions, diluting their impact.

Should Student Loans Have Interest Rates At All?

Alexander Holt writes that the recent initiative to reduce interest rates will hardly have the expected impact. Holt states that the interest rate reduction would only reduce the average monthly payment for borrowers by about $16. This would hardly make a dent. In fact, such a move might even increase the burden on taxpayers. Holt suggests that eliminating interest rates on student loans might be the best solution.

To offer interest-free student loans, the government would need to secure the funding first which would typically get recovered by increasing taxes. Holt argues that this might not be necessary. The federal government could instead add the cost of lending and servicing into the original amount borrowed — the origination fee. This means that students would be able to borrow the amount needed to cover the fee as well. The government would also be able to avoid any losses emanating from the elimination of the interest rates on student loans.

Borrowers are often suspicious of origination fees because they have traditionally been a source of hidden costs. Holt contends that the government could treat student loans as an exception as far as origination fees are concerned. Charging origination fees would be more beneficial than interest because the fee would:

  • Enhance the transparency of the loan
  • Reduce anxiety among borrowers and,
  • Fine-tune the loan program to help a higher proportion of low-income borrowers

Illustrating the Concept of an Origination Fee on Student Loans

Holt explains that student loans typically accrue interest while the students are still in school. During this period, students do not generally make any repayments toward their loans. Once they are out of school, they find their loan balances have swelled considerably in comparison to the amount they borrowed.

He goes on to illustrate his suggestion with an example: A student borrower takes out a loan of $10,000 for a four-year program at an interest rate of five percent. If the borrower made the scheduled monthly payments for 10 years after graduating, the individual would have paid approximately $14,000 in total. Instead of this, Holt suggests that it might be better to inform the borrower that the borrower’s loan balance is $14,000 at the outset, with the origination fee of $4,000 forming a part of the loan balance. This would nullify the need to charge interest at all while simultaneously saving the borrower unpleasant surprises of inflated loan balances.

The idea might seem radical, but it could potentially solve a major problem with the student loan process.