Consolidation Loans: Redesign Options and Considerations

Publication Date: June 2004

Publisher: Library of Congress. Congressional Research Service

Author(s):

Research Area: Banking and finance; Education

Type:

Abstract:

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?