Federal Student Loans: Interest Rates Going Up?

Partisan battles in Washington are jeopardizing efforts to prevent interest rates on federal student loans from automatically doubling on July 1.  The House last week approved legislation that would replace the current fixed rate on Stafford loans with a variable rate pegged to Treasury Notes interest rates that would be capped at 8.5%. 
 
The White House has threatened to veto the bill claiming that it will make it more difficult for middle income students to get the financing they need for college.  Senate ed committee chairman Harkin (D-IA) is proposing a two-year extension of the current rate to give Congress time to work out a better plan.
 
House ed committee chairman Kline (R-MN), at a breakfast appearance last week, defended the House bill saying it would provide affordable interest rates to students and reduce costs to the taxpayer.

Why is the cost of higher education rising?

Actually, there is a simple reason that educational costs are so high, and we should not be surprised. Higher education lending is no different than any other market. Lenders assess the risks of loans based on a variety of criteria. Interest rates are set based on complex models for loans if they are approved. When was the last time you got the advertised rate when buying a car? When the government leverages the taxpayers against the loan risks, lenders are more likely to approve more loans and at lower rates that they would otherwise. Eventually, when it becomes common practice, the public demands and feels entitled to those new common terms.
 
When universities know that they will be paid either way, they have no incentive to compete with each other, but effectively collude with lenders and regulators (government), letting tuition prices rise as a result of the intervention into the market. This is what happened in the housing crisis and subsequent bubble. Now its happening in the education lending market, despite the lessons that should have been learned.
 
The effort by politicians and lenders to make education more affordable has had the opposite effect. What's scary is that the results of these actions can be assessed based on basic microeconomic principles, yet the failure continues.

A better solution would be to let the market react and the interest rates rise. Lenders view government-guaranteed loans as reduced risk (since taxpayers are on the hook if loans go into default), and those risks are necessary to stabilize a financial market like loans for homes, education, etc. Without risk, lenders lend to borrowers who may not be as capable of paying back loans in a timely manner, which has led to students being shackled with educational debt for terms stretching to near mortgage lengths and further.
 
Continuing to suppress rates at such a low rate only encourages the continuation of this practice by lenders that approaches predatory, such as has been seen in the housing market. The trouble with either of these scenarios is that eventually those low rates will return to higher levels, either voluntarily or when the bubble bursts. A gradual deflation of the higher education lending bubble would be far less disastrous that the current trend.

More: The Economics of Liberty: Bubbles, Intervention, Money, Debt, Education