• October 22, 2014

To Fix Student Lending, Rethink the Concept

This past fall, Occupy Wall Street protesters around the country called for far-reaching changes in our society, including forgiveness of student-loan debt. While we believe loan forgiveness is a bad idea for a variety of reasons, we also think the protesters are right in calling attention to the nation's Byzantine and inefficient system of student lending. Here are a number of beneficial steps that policy makers can take to begin to fix our student-loan system.

Drop bankruptcy protection for private student loans.

 Since 2005, private student loans have been nondischargeable in bankruptcy. But the government already provides $104-billion in loans for higher education, a sum that should meet the needs of students. Moreover, what is the rationale for setting limits on the total amount students can borrow in the federal loan programs, but then allowing private student loans to circumvent those limits?

Nor is this an oversight with no ill effect—a new report of ours shows how such loose lending leads to higher tuition. Essentially, because there is no measure of quality in higher education, colleges can't compete based on either quality or value. Colleges, therefore, compete among themselves for relative standing, meaning there is no limit to what they will spend in the pursuit of excellence. Because colleges have an insatiable need for revenue, it is only a matter of time before they exploit the increase in the ability of students to pay that loans provide. Law schools are the best example of this phenomenon, and the predictable result is huge tuition inflation and unsustainable debt acquired by many students.

Ending the special protection for private loans would be a good start to putting a stop to these trends (though only a start) and would encourage lenders to perform due diligence, colleges to tame their tuition increases, and students to choose less-expensive options.

Eliminate Perkins Loans.

 The Perkins Loan program is a campus-based aid program in which colleges are given significant discretion in determining the recipients of federal aid, which is the first red flag. Red flag No. 2 is that the allocation of aid among institutions is not determined based on the need of students, but rather by past allocations. The aristocratic colleges have been remarkably successful in defending their unjust perks, so much so that a student at a very high-cost institution is 15 times more likely to receive a Perkins Loan than a student at a lower-cost institution. We find this a highly questionable use of scarce financial-aid dollars.

Stop using cost of attendance to determine aid eligibility.

 Currently, the amount of aid a student qualifies for depends in part on his or her college's cost of attendance, which is the total amount needed to complete a full year of college. Consequently, those students enrolled at an expensive college will tend to be eligible for more aid than those students enrolled at lower-cost institutions. While grant caps and loan limits prevent this from being an unmitigated disaster, at the margin, this does nothing to encourage cost control on the part of colleges and cost consciousness on the part of students. A much-better approach would use some reasonable base for every college or program, such as the median cost to attend. This would give more-expensive colleges an incentive to cut costs and provide lower-cost colleges more resources with which to expand or improve.

End the income-based repayment program.

 Under this new plan, if participants pay up to 15 percent of monthly discretionary income for 25 years, any remaining balance is forgiven (meaning taxpayers eat the cost), and President Obama recently authorized lowering these to 10 percent and 20 years, effective this year. This program is problematic for a range of reasons, but the most important one is that if students are borrowing too much money to realistically pay back, then the solution shouldn't be to set up a Rube Goldberg-type scenario that allows them to keep borrowing too much in the hope that we'll figure out how to pay for it in 20 years. To borrow a wonderful phrase from Wolfgang Münchau, "This is the equivalent of putting explosives into a can, before kicking it down the road."

Revamp the government's student-loan program.

While all of the above ideas are worth pursuing, the most fundamental goal for fixing student lending is a rethinking of the concept itself. Almost four decades ago, the Carnegie Commission on Higher Education noted that "Traditional loan concepts, borrowed from the world of commerce and industry where the physical plant suffers from depreciation and obsolescence, are not equally appropriate to investment in human capital." As a country, we have yet to come to terms with this and develop new debt instruments based on the characteristics of human rather than physical capital.

Human capital lending would likely treat the loan recipient's higher earnings from education as collateral. One way to accomplish this is through income-contingent loans. A problem with the existing systems in other countries is that the government does the lending. We feel that having the private sector do the lending has a number of advantages.

As described in a study of ours, the first advantage is that interest rates (and potentially loan amounts) are freed from politics. When politicians set interest rates, they do not do so with the return on investment and the riskiness of the loan in mind, with predictable budgetary consequences. The second advantage is that it would free up billions of government dollars a year for other uses. The third and most important advantage of private lending over government lending is that the interest rate would vary based on the borrower's choice of major and academic performance.

For instance, a private lender interested in being repaid would not offer the poorly performing law student (a field with a surplus of graduates) a loan on the same terms as the stellar nursing student (a field with a shortage of graduates), but that is exactly what the government does. Relying on private lending would increase the number of nursing students and decrease the number of law students, a socially desirable outcome that cannot be achieved when the government is the lender.

Specifics aside, the larger point is that efforts to restructure student loans to stop treating them like an investment in a factory and start treating them as an investment in human capital are very promising for students and for society.

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Andrew Gillen is research director at the Center for College Affordability and Productivity and an adjunct professor of economics in Washington, D.C. Richard Vedder is director of the center, an adjunct scholar at the American Enterprise Institute, and a professor of economics at Ohio University.

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