The consolidation option for federal student loans allows borrowers to consolidate one or more loans into a single loan and to extend the time to repay that debt. For loans originated before July 2006, borrowers also have the right to consolidate a variable-rate loan into a fixed-rate loan at the short-term interest rate. The option adds substantial costs to the federal student loan programs.
Accurately estimating the cost of the consolidation option to the government presents a number of technical challenges. To begin with, market prices cannot be used to estimate that value because the student loan consolidation option differs substantially from private options. For example, holders of variable-rate student loans have the option to convert them to a fixed-rate loan at either the prevailing short-term interest rate or the rate for the next year. There is uncertainty as to when a borrower will consolidate and at what interest rate, because some borrowers do not consolidate when it is most financially advantageous to do so, and others do not consolidate at all. Borrowers’ failure to take full advantage of consolidation reduces the cost of the option to the government.
This Congressional Budget Office (CBO) background paper describes the valuation of a typical student loan consolidation option, one in which a variable-rate 10-year loan is converted into a fixed-rate loan with a term to maturity of 20 years. That case was one of many that CBO analyzed to find the expected cost of the option, which was reported in an earlier CBO paper.
Accurately estimating the cost of the consolidation option to the government presents a number of technical challenges. To begin with, market prices cannot be used to estimate that value because the student loan consolidation option differs substantially from private options. For example, holders of variable-rate student loans have the option to convert them to a fixed-rate loan at either the prevailing short-term interest rate or the rate for the next year. There is uncertainty as to when a borrower will consolidate and at what interest rate, because some borrowers do not consolidate when it is most financially advantageous to do so, and others do not consolidate at all. Borrowers’ failure to take full advantage of consolidation reduces the cost of the option to the government.
This Congressional Budget Office (CBO) background paper describes the valuation of a typical student loan consolidation option, one in which a variable-rate 10-year loan is converted into a fixed-rate loan with a term to maturity of 20 years. That case was one of many that CBO analyzed to find the expected cost of the option, which was reported in an earlier CBO paper.
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