Buried in President Obama's proposed budget is a big change to federal student loans. According to the Department of Education's draft budget, Obama wants the interest rate on federal loans to be pegged to market rates annually. Currently, the rate is 6.8 percent for most loans, with a subsidized rate of 3.4 percent for needy undergrads. Congress set the current rate for loans in 2001, and in 2007 voted to lower the subsidized rates. The economy's changed since then, but the rates haven't been adjusted to reflect today's low-interest-rate environment.

 

Under Obama's proposal, the interest rate on student loans will be set each year based on the government's borrowing costs. For subsidized loans, the rate would be 0.93 percentage points above the rate on a 10-year Treasury bond; unsubsidized loans would be two percentage points higher than that, and grad student loans one more percentage point higher still. So at the current 10-year T-note rate of a little over 1.8 percent, subsidized loans would be about 2.75 percent, unsubsidized loans would be 4.75 percent, and grad student loans would be about 5.75 percent—all lower than the current fixed rates.

Of course, interest rates will rise as the economy improves, so some consumer groups criticize Obama's plan for not having a cap on rates. In the days when federal loans previously were pegged to market rates, they were capped at either 9 percent or 8.25 percent, depending on the year.

Obama's plan does expand the Pay As You Earn program that caps federal student loan payments at 10 percent of a borrower's income, and forgives the balance of the debt after 20 years (or 10 years for graduates in public interest jobs). That could effectively reduce rates for graduates with low incomes, or who borrow a lot (and therefore have big balances that are ultimately forgiven).

Republicans generally support tying federal student loan rates to the broader market. It's not clear how Democrats will react. If Obama's proposal doesn't go through, and Congress doesn't make other changes, the rates on subsidized loans are set to double to 6.8 percent this summer.

By Karen Weise, reporter for Bloomberg Businessweek in New York.
Follow her on Twitter @kyweise.