The Student Loan Consolidation Option: an Analysis of an Exotic Financial Derivative

The authors wish to thank John Kolla and Marvin Phaup for help and comments on this project. Lucas gratefully acknowledges support from the Searle Foundation. Working papers in this series are preliminary and are circulated to stimulate discussion and critical comment. They are not subject to CBO's formal review and editing processes. The analysis and conclusions expressed in them are those of the authors and should not be interpreted as those of the Congressional Budget Office. References in publications should be cleared with the authors. Papers in this series can be obtained at www.cbo.gov/publications. Abstract The federal government makes subsidized federal financing for higher education widely available. The extent of the subsidy varies over time with interest rate and credit market conditions. A loan provision that adds considerably to the size and volatility of the subsidy is the consolidation option, which allows students to convert floating-rate federal loans to a fixed rate equal to the average floating rate on their outstanding loans. We develop a model to estimate the option's cost and to evaluate its sensitivity to changes in program rules, economic conditions, and borrower behavior. We model borrower behavior using data from the National Student Loan Data System, which provides new insights on the responsiveness of consumers to financial incentives.