Sen. Marco Rubio Student Loan Plan Benefits Vast Majority of Future Borrowers
Senator Marco Rubio (R-Fla.) has jumped into the student loan policy ring with a series of new proposals, introduced in the Senate as the Leveraging Opportunities for Americans Now Act of 2019 — or the LOAN Act <groan>, for short.
Here’s a brief look at the Marco Rubio student loan proposal and how it will affect most borrowers:
Among Rubio’s proposals:
- Beginning in 2021, borrowers federal direct student loans will no longer have to pay interest as we know it. Instead, most loans will be originated with a 25% “financing fee.” Exceptions: Federal Direct PLUS loans made on behalf of a dependent student or used for a graduate or professional program will have a financing fee of 38% of the amount of the loan.
- This fee will be paid over the life of the loan, and will not compound over time.
- Borrowers can still get a discount on the funding fee by paying it off early.
- Participants will be automatically enrolled in an income-driven repayment plan in which they pay a minimum of 10% of their incomes in excess of $10,000, except in times of unforeseen financial hardship.
- Those currently enrolled in school but haven’t graduated before this date have their choice to continue using the current loan system or the new, interest-free loans created by the LOAN Act.
- Borrowers can still go with a 10-year repayment plan if they choose. However, the new proposal under the LOAN Act with the 10% over $10,000 cap will be the default option.
- Those earning below $10,000 per year would not have to pay anything on their loans.
- Incomes would be verified by the Treasury Department using individual tax filings.
Who benefits from the Marco Rubio Student Loan plan?
The primary benefit of Marco Rubio’s student loan plan is that it would effectively set a cap on student loan interest accrual – and take away most of the pressure to pay it down. Since the fee is non-accruing, there’s no risk that the loan balance could balloon out of control over time if the borrower is unable to repay as planned.
“If you take out a $10,000 loan, rather than charging interest that grows over time, there would be a flat fee of about 25% of the size of the loan, so you’d owe $12,500,” exclaimed Rubio. “But that fee doesn’t grow. That’s what you owe. A $10,000 loan costs $12,500, and that’s what it’s going to cost the whole time. You don’t have to worry about if it takes you 20 years, that could grow to $25,000, you know? It could double!”
Marco Rubio’s Student Loan plan would most benefit those who expect to take a long time to pay off the loan. That would include those getting expensive degrees in lower-paying fields. For undergraduate loans, if you have reason to believe it will take longer than 10 years to pay off your loan, you may benefit from the Rubio plan.
If you expect your earnings to be sufficient to pay off the loan in a shorter amount of time, then you’ll probably want to take the traditional route.
Calculating the break-even point – Undergraduate loans
Currently, the average federal student loan interest rate is 5.05% for undergraduate loans, 6.60% for unsubsidized graduate loans, and 7.60% for PLUS loans.
Compare what it would take to pay off an original loan value of $100,000 under the two schemes at current interest rates:
Under Rubio’s plan, the $100,000 loan would immediately convert to a balance of 125,000, but it would not compound anymore. The interest rate is, therefore, zero percent on a higher balance. To pay it off in 25 years, it would take a monthly payment of $416.67.
If you borrow $1oo,000 at a 5.05% interest rate in a traditional loan it would take a monthly payment of $587.51.
But if you look to pay it off in ten years, the difference between the two plans is very narrow.
A ten-year repayment schedule on a $ 100,000 traditional loan at 5.05% would require a payment of $1063.10. Under the Rubio plan, the original balance would be $125,000, but the monthly payment is $1041.67. That’s still a slight advantage for the Rubio plan.
At today’s interest rates, the breakeven point for undergraduate loans is 117 months. That’s just three months less than ten years. If you can pay the loan off in less than 117 months, then in theory, you’re better off with a traditional loan.
The0ry and reality are very different things. If you plan to put your undergraduate loans into deferment while you pursue a graduate degree, this will tilt the balance of the equation strongly toward the Rubio plan.
Here’s why: The loans you take out in the first couple of years of a four-year undergraduate degree have a longer time horizon than loans you take out in your junior and senior years. Unless you make interest payments while in school, a $100,000 loan you take out as a freshman at 5.5% is going to have a higher balance by the time you graduate. Specifically, your balance is going to be 23.89% higher after four years. And if you defer that freshman year loan for an additional two years of graduate school, it’s going to be 37.89% higher, and continuing to compound.
In each case, you are better off under the Rubio plan with your early undergraduate loans – capped at 125% of the original loan amount – even with an aggressive repayment plan.
Calculating the break-even point: Graduate loans.
Since graduate level loans have a higher average interest rate, the math works out differently – and generally in favor of the Rubio plan. This is because while traditional graduate loans have higher interest rates, the Rubio proposal assigns them the same 25% non-accruing funding fee as undergraduate loans.
To pay off the average current graduate school loan at an interest rate of 6.60% in 25 years, you would need to maintain a monthly payment of $681.47. Under the Rubio plan, you would have to pay $416.67 each month. Again, the strong advantage is to Rubio’s proposal for long-term borrowers.
At the ten-year point, the two plans are pretty much a wash. Rubio’s proposal would require a monthly payment of $1041.67 per $100,000 borrowed (after adding the 25% financing fee to get an original non-compounding balance of $125,000. At the same time, a ten-year traditional loan balance of $100,000, compounding at 6.60% would have a monthly payment of $1140.57.
If you are going into a high-paying field, it may make sense to stick with the conventional type of loan – and pay it off like crazy. But for it to make sense, you can’t defer the interest while you’re in school and you would have to pay it off well under 10 years. Otherwise, the advantage of the lower balance and the ability to prepay the loan at a discount is consumed by the interest rate.
Parental PLUS Loans
The math is different for parental PLUS loans. These loans are less likely to be deferred while the student is in school (the parent borrower is still working and can presumably make payments). But the finance fee under Rubio’s plan is much higher: 38% compared to 25% for graduate and undergraduate loans. The higher funding fee reflects the higher interest rate on these loans.
This means that to borrow $100,000, the parent would have to incur a starting balance under Rubio’s plan of $138,000.
To pay the loan off in ten years, that would require a monthly payment of $1150 per month. A traditional loan at 7.6 percent interest would require a monthly payment of $1192.24.
So with an amortization period of ten years, the Rubio plan would save parental borrowers $42.24 per month.
Every situation is different, and there are other factors that may affect the decision of whether to adopt Rubio’s proposed methodology for a student loan or stick to the traditional compounding interest on a lower original balance.
For example, students who expect to come into a large inheritance or the release of funds from a trust that would enable them to prepay their student loan balances would be better off opting for traditional loans their last couple of years in school – but not for their first year or two, if they are deferring loans through graduate school.
Also, some or all of your traditional student loan interest will be tax deductible. There is no provision for the tax deductibility of the funding fee in Rubio’s plan. This weighs slightly against the Rubio plan, especially for those in higher tax brackets or in states that have high-income taxes.
If you plan on refinancing as soon as you get out of school, and pay that refinanced loan off very quickly, you will also be better off with a traditional loan, as long as you don’t let it accrue in deferral for very long.
These are likely outliers, however. Most borrowers defer payments for 1-6 years while the student completes his or her course of study, Almost all borrowers will be better off opting for the Rubio plan – especially early in their academic careers.
Game, Set and Match: Rubio
Putting it all together, the vast majority of student loan borrowers are likely to benefit substantially from Rubio’s proposal. Since most borrowers put their loans into deferment while they are in school, much of the 25% funding fee in Rubio’s plan is already baked into the cake. The only graduate or undergraduate borrowers who would be better off paying interest on the smaller-balance traditional loans are:
1. not deferring undergraduate loans while in graduate school or even as undergraduates, and 2. paying these loans off in well under ten years.
If your payments would be reduced by enrolling in an income-driven repayment plan such as IBR or REPAYE, you would almost certainly be better off under Rubio’s plan.
The Rubio plan also has the advantage of avoiding some of the objections to the competing plan from Senator Elizabeth Warren’s campaign, which we detailed here. And it would come at just a tiny fraction of the cost to taxpayers.
And perhaps most importantly, by eliminating compounding interest and capping the loan with a non-accruing balance at 0% interest, Rubio’s plan eliminates the nightmare scenario of a financial setback or career disappointment causing a student loan to spiral hopelessly out of control.
Jason Van Steenwyk is an experienced financial industry reporter and writer. He is a former staff reporter for Mutual Funds, and has been published in SeekingAlpha, Nasdaq.com, NerdWallet, Value Penguin, RealEstate.com, WealthManagement.com, Senior Market Advisor, Life and Health Pro and many other outlets over the past two decades. He is also an avid fiddle player and guitarist. He lives in Orlando, Florida.