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A couple of students safely parachute beyond the fluctuating/dangerous interest rate lines, landing safely on the flatline, showing the positive impact of 0% interest.
Calum Heath for Money

Federal student loan borrowers won’t have had to pay a dime of interest on their debt for nearly two years by the time the pandemic-era forbearance period ends in February.

While most of the focus on this relief has been on how borrowers have been able to skip payments altogether, data from the Department of Education suggests that not having to pay interest has saved borrowers more than $90 billion so far.

For those who’ve been able to take advantage of the interest-free period, it’s been a powerful opportunity to make headway paying down their debt. At the very least, it’s been a chance for millions of borrowers to finally stop watching their balances grow, despite making regular payments.

“It really is true that interest is what kills you,” says Mark Huelsman, a fellow at the Student Borrower Protection Center. “When people can actually pay down debt, they start thinking of their own finances in a different way. They start saving for long-term needs.”

There’s been much debate over the past few years regarding major student debt relief proposals, like widespread cancellation, versus smaller changes, like improving repayment options. But not much has been said for a measure like permanently removing interest on federal student loans altogether. Now that it’s already been in place for over a year, could 0% interest on federal loans be a solution to the $1.7 trillion student debt crisis?

Why do federal student loans even have interest rates?

Since 2013, interest rates on new federal loans have been set each year, based on current market conditions. (More specifically: they’re based on the 10-year Treasury note with a fixed add-on rate for each type of loan the government offers.)

According to figures originally obtained by Slate that Money later confirmed, in 2019 (the last “typical” year for student loan repayment), federal borrowers paid more than $70 billion back to the government. Of that total, around $22 billion, or nearly one-third, went toward interest alone.

So where does that money go? Does it pay the loan servicers, like Nelnet or Fedloan, that manage the government’s student loan repayment? Is it how Department of Education employees get paid?

Nope. Like all other government revenue, your interest payments simply go back to where they originally came from: the U.S. Department of the Treasury.

Essentially, the entire federal government’s annual budget is based on that pool of revenue. Congress votes to approve a budget each year, and money is then allocated to each department.

Proponents of charging interest say the government needs to do so because it’s a fairly unique lending situation: Unlike a car or mortgage loan, student borrowers don’t have to offer up any form of collateral. Private student loans come with interest rates up to 13% and often require a credit-worthy cosigner, whereas the federal government will lend to almost any 18-year old. Plus, rates for undergraduate loans haven’t exceeded 6.8% in the past two decades, and current rates are much lower at just 3.73%. Federal borrowers receive large sums of money that require no down payment with no guarantee that it’ll ever be paid back.

“The interest rate on a federal student loan is lower than any other rate for an unsecured loan you can get,” says Jason Delisle, a senior policy fellow at the Urban Institute.

Charging interest is how the government ensures that the money going out matches the amount coming back in. The goal is that the interest that’s paid will be able to keep the inflow and outflow relatively balanced.

Still, the system isn’t perfect: In a 2018 report, the Congressional Budget Office projected that the federal government loses around $0.13 for every dollar of undergraduate subsidized loans it issues (these loans don’t accrue interest until after you leave school) and $0.02 for unsubsidized loans (these accrue interest while you’re at school, but you don’t have to pay them back until you leave).

Who would benefit most from keeping interest rates at zero?

Even with rates that are lower than some students would be able to qualify for on the private market, many federal borrowers are drowning under interest. In fact, before the current forbearance period, millions of borrowers made monthly payments so small, they didn’t even cover the accrued interest, so their total debt continued to grow. This included the growing number of people enrolling in income-driven repayment plans with the goal of having their debts eventually forgiven, as well as those who had been granted forbearance or had defaulted on their loans but had begun paying them back.

Eliminating interest means that for these borrowers, many of whom are from low-income and minority backgrounds, their payments would actually chip away at their debt each month.

And yet, critics of expansive debt relief proposals stress how the majority of student debt (56%) is held by Americans in the top 40% of income levels. Many of those borrowers have professional degrees that allow them to earn more money, despite being saddled with larger amounts of debt. And crucially, their loans from graduate school carry higher interest rates — often around 7% — so eliminating interest would generally save those borrowers more each month than it would undergraduate borrowers.

“You end up providing a lot of benefits to people that most Americans would think don't need it,” Delisle says.

But looking at student debt in proportion to peoples’ wealth — their total assets, including savings and owning a home, minus debts — paints a different picture.

When you organize the population of the U.S. by wealth, the bottom 20% hold 55% of all student loan debt. They might still have a higher than average income, but the massive amounts of money they collectively owe keeps them buried under debt, and often struggling to meet major life milestones like buying a home or even retiring. Put simply: Eliminating interest could help those borrowers pay off debt more quickly so they can actually start to build wealth.

“You have many students going to school, taking on debt and being broadly unable to pay it off,” Huelsman says. “They either become delinquent or just unable to contribute to the economy and save money.”

Should the government cancel student loan interest forever?

Matthew Reed, the vice president for academic affairs at Brookdale Community College in Lincroft, New Jersey and a columnist for Inside Higher Ed believes removing interest is a more straightforward and less costly option than more complicated cancellation proposals.

Take one of President Biden's policy proposals from his campaign: He wanted to cancel undergraduate student debt for those earning less than $125,000 — but only if you went to a public school or a private university that primarily serves ethnic minority groups. Vice President Kamala Harris’s proposal had even more caveats: $20,000 worth of federal debt cancellation but only for Pell Grant recipients who successfully start and operate a business for three years in a disadvantaged community.

“It is a beast to get that sort of information,” Reed says. “By making it simple to administer, you cut administrative costs. Zero is zero is zero.”

He also wonders if a universal interest waiver program, even if it would technically put more money back into some peoples’ pockets than others (and even if some of those people were well off), could get more support because it’d be perceived as more fair on principle.

“It’s not what most people would perceive as a handout because [borrowers] would still pay back every dollar they owe,” he says. “You need broad support or else these proposals just don’t survive.”

But Delisle believes a proposal like removing interest rates is short-sighted.

“It's a sort of lazy policy that doesn't attempt to determine who needs help and who doesn't,” he says.

As far as costs go, the Biden administration has noted that the federal student loan program is already forecasting $68 billion in long-term losses by the end of the pandemic forbearance period. While that number is based on total missing payments, not just interest, Delisle notes that the cost of permanently removing interest rates would likely need to be made up somehow.

“It's just very costly to reduce or waive interest on loans. To bear that cost, either taxes have to go up or spending has to come down in the long run,” he says.

Congress ultimately does have the power to do either, and eliminating interest isn’t a totally new policy idea. Sen. Marco Rubio (R-FL) has proposed replacing student loan interest with a one-time origination fee tacked onto the amount of a borrower’s loan. But as with most political issues, getting broad consensus on raising taxes or reducing spending would be an uphill battle.

Any type of cancellation would not be a “cure-all”

The problems with ballooning student debt wouldn't be solved by canceling interest rates alone. For one, that doesn’t address the issue of why so many students need to take on so much debt in the first place.

“It's not a perfect solution, obviously, because it only solves one part of the problem. It doesn't solve the problem of disinvestment in public higher education,” Reed says.

Despite public universities subsidizing more than half of undergraduate students’ tuition on average, Americans spend nearly twice as much on higher education as the average developed country, according to a 2018 report from the OECD.

The risk that comes with financing higher education through debt can also vary dramatically depending on factors like where you go to school. For instance, students who attend private for-profit colleges default on their loans at a rate of 15.2%, whereas the default rates for public and private non-profit attendees is 9.6% and 6.6% respectively.

Keeping interest rates for all federal loans at zero may be a more politically viable option than broad cancellation. But as Huelsman notes, there are other distressing consequences that come with owing tens or hundreds of thousands of dollars for your education, and those will need to be addressed by more robust legislative measures.

“The interest is a big part of it, but there are people with completely unmanageable student loan balances,” he says.

More from Money:

Most Student Loan Borrowers Won't Have to Make Payments Until February

Biden Has Forgiven $9.5 Billion in Student Debt. What About the Other $1.6 Trillion?

Should Biden Cancel Student Debt? The Loan Forgiveness Debate, Explained