Charging interest on student loan debt is actually a good thing

The student debt forgiveness movement took a major hit when the Supreme Court struck down the Biden Administration’s loan forgiveness plan. But many advocates have pivoted to a new proposal: canceling student loan interest. 

A growing number of people from both the right and left have concluded that student loan interest is unnecessary, or even harmful. Critics portray student loan interest as a runaway expense that unfairly sneaks up on borrowers. When compared to outright debt forgiveness, slashing interest rates could sound like a moderate compromise. Congressional Democrats just introduced legislation to cut student loan interest rates to zero percent.

This agenda has already influenced the Biden administration’s changes to income-driven repayment (IDR) programs, which shield low-income borrowers from costly payments and defaults. IDR reduces monthly payments based on a borrower’s income and family size. For some, it cuts their required monthly payment to $0. The Biden administration’s changes will increase the number of people who would make no payments toward their loans. And, crucially, these plans eliminate interest collection beyond the required monthly payments. 

But don’t be fooled — cutting interest rates is just another way to accomplish debt forgiveness, this time through the back door. For instance, the Covid pandemic student loan payment pause, during which no interest was collected, cost American taxpayers $230 billion in foregone interest accrual. Besides being incredibly costly, these interest collection reforms would significantly distort the financial system. 

Interest rates exist for a few good reasons. First, they help the government recoup losses due to inflation. Without interest, a one-year $1,000 loan taken out in 2022, when the inflation rate was 8%, would result in a repayment worth around $930. This might not seem like a huge loss at the individual level, especially if the inflation rate returns to the Federal Reserve’s desired 2%. However, with 43 million borrowers and more than $1.6 trillion in outstanding federal student loan debt, even a single year of high inflation with no repayment — such as the pandemic payment pause — could cost the government hundreds of billions of dollars. 

Second, lenders face an opportunity cost when they lend money. Even if the borrower will repay the money in the future, the lender cannot spend money that is currently lent — the lender faces a liquidity constraint. On the other hand, the borrower receives access to money that they would have only obtained in the future. To compensate the lender for this temporal inconvenience, the borrower pays a fee in the form of interest. In fact, without interest, there would be no incentive to lend money at all.

Finally, lenders use interest to compensate for the risk of default. Student loans have a relatively high default rate, with pre-pandemic rates at 10%. For comparison, pre-pandemic delinquency and charge-off rates for consumer loans were just above 2%. Student loans are also unique in that the government cannot recover any costs through collateral. Since some borrowers will inevitably default, the government must charge a higher interest rate to break even or turn a profit. 

Some may say that interest rates on student loans are unjustifiably high. If the interest can’t be eliminated, they argue, it should at least be lowered to help struggling borrowers. But if it were the case that interest rates were too high, the government should turn a profit off of the loans. It doesn’t. Since the late 1990s, the government has lost $200 billion from the student loan program. 

Another fashionable policy suggestion is eliminating interest capitalization on student loans. Interest capitalization is the process by which unpaid interest is added to the loan balance, upon which future interest is accrued. Proponents of eliminating interest capitalization misleadingly claim that this is unique to student loans. Yet they ignore why this phenomenon is uncommon with other kinds of loans: Student loan payment plans like IDR allow borrowers to pay an amount so small that it doesn’t even cover the interest. Other loans require the regular payments to cover both the interest and a portion of the principal so the loan can be repaid over time. 

We need a student loan system that is both merciful and fair. Allowing borrowers to claim bankruptcy and placing restrictions on loans would achieve this goal. Borrowers who truly struggle to repay their federal student loans should receive the escape hatch of bankruptcy, just like any other loan. At the same time, the government should restrict loan disbursements to those with the best economic returns to prevent such hardship in the first place. 

Our current system fixates on mercy, but disregards accountability, thus creating a moral hazard. Even those who oppose student loan interest acknowledge the problems with our excessively liberal lending system. Researchers for a recent Jain Family Institute report admitted that it was “increasingly the case that people who were always going to have low earnings no matter their educational attainment are also overloaded with student debt.” It is abundantly clear that funding every person to attend college isn’t working.

Every suggestion to reform student loan interest will result in massive amounts of government spending. Don’t be tricked by the technical language and the sneaky redefinitions. These reforms are all an attempt to shoehorn loan programs into costly grant programs. Supporters of these policies should have to justify why Americans should further subsidize the already bloated higher education establishment. 

Neetu Arnold is a Research Fellow at the National Association of Scholars and a Young Voices contributor. Follow her on Twitter @neetu_arnold.