Why are student loan interest rates low when the repayment terms seem worse to lenders?

Question

I've heard that student loan interest rates are typically low compared to other kinds of loans.

I think I get the subsidization part of it, i.e. the federal government discounts interest, presumbly to support higher education.

But why would even unsubsidized loans have lower rates than other types of loans, when the repayment terms seem to favor the borrowers? That is, typically the lender doesn't see any repayment until after graduation (or unenrollment), and doesn't collect any interest during that period, right? So what's in it for the lenders to charge such low interest?

It's possible I just don't know the first thing about how lenders make money. And Googling "Why are student loan interest rates low?" only turns up results about why student loan interest rates are high.

Answer 1

typically the lender doesn't see any repayment until after graduation (or unenrollment), and doesn't collect any interest during that period, right?

Interest payments on subsidized loans are paid by the government. If you have an unsubsidized loan and choose not to pay the interest during school, it accrues - meaning the balance of the loan increases by the interest. So while the stated rate on which interest is charged is lower, the effective rate (meaning the rate that corresponds to the amount of interest paid relative to the amount that was borrowed) is higher.

The main reason for the lower rates is that federal student loans are typically not dischargeable in bankruptcy. There is a forgiveness benefit available if you work full-time in a public service job for 10 years. Since these jobs are in underserved areas, they're likely underpaid, so you're trading 10 years of a low salary for the potential benefit of cancelling what's left of your student loans (and the non-financial benefit of serving society). There are other ways to defer payments, or consolidate them into other loans, but there's virtually no way to just get rid of them, unlike personal loans that can be discharged in bankruptcy or consumer loans that can be recovered in a repossession. You basically have to die, become disabled, or work in an underpaid public sector job.

So while the payments can be deferred, the government is still more or less guaranteed to get its money back, hence very low risk of default.

Private student loans are a different story - they are bankruptable, so they have a higher rate to compensate for the additional risk of default.

Answer 2

Interest rates are priced according to a couple of principles [I'm ignoring high interest prices charged because a company 'can', like payday lending spots that rely on customer desperation and lack of financial literacy to charge exorbitant rates]

• What is the cost of 'risk free' lending?, ie: government Treasury bills or similar. If the overall market rate for government debt is lower, then all other interest products should have similar decreases. Let's assume this is a rate of 1% currently.

• What is the risk of default? The more likely someone will fail to pay their interest, the more the bank needs to charge everyone else a higher amount to compensate. Simplistically, if a risk free rate would earn 1%, and 20% of all credit card balances will go unpaid, then the credit card company would need to charge about 21% interest to end up still making a net 1% profit. Note that failing to pay your credit card balance for 2 years is great for the credit card company - balances will accrue, and they will salivate at the chance of getting some penalty and interest payments in a short time frame. It is failure to pay over 10 years, or a bankruptcy claim, that makes the credit card company nervous.

• What recovery of security is possible? If you have a mortgage on a house, or a secured car loan, then failure to pay will allow the bank to take ownership of that asset, sell it, and give back any scraps left over after making themselves whole. For some assets, the value of this security is lower - like for a car, it might drop in value 30% when you drive it off the lot, and you would become immediately 'underwater', meaning selling the car wouldn't give the bank enough money to get their loan repaid. So they might charge 5% interest on a car loan. But a house mortgage is guided by regulations that require down payments etc., meaning you are less likely to be underwater, and therefore a rate of 3% might be possible. Remember - if you fail to pay a student loan, a repo man can't just come and take your diploma away.

And, particularly relevant for this question:

• What is the chance of default aided by a bankruptcy claim?

Most student loans in the US cannot typically be discharged in bankruptcy [the theory here is that you gain the knowledge of a degree, and that gives you permanent value, so it would be 'unfair' for you to still retain the value of the gained knowledge but not have to pay for it. I will leave it to the reader to consider whether this becomes an albatross over the neck of someone who, declaring bankruptcy, clearly never got a good career out of their degree].

This lack of consumer protection significantly reduces the risk of interest to the lender ever being unpaid. Because the risks are lower, lenders are happy to grant 'beneficial' terms to students, including deferral periods. That interest isn't eliminated, it is just paused. And to the lender, given the risk is lower, it matters less when that money comes in. In fact, many lenders would be happy for their loans to continue to be deferred, and accumulate more and more compounding interest.