At the beginning of 2011 the portfolio of the federal government for education loans was nearly one trillion dollars. The portfolio consisted of loans for students currently in college extended either directly by the Department of Education or loans from financial institutions like Sallie Mae and banks with repayment guaranteed by the United States Treasury as well the education loans of students who had graduated from college or had quit before graduating but had not been fully repaid. Its size exceeded the credit card debt of the American population in early 2011 and it continues to grow; whatever part remains unpaid contributes to the national debt.
An optimist views the large portfolio of student debt as "no problem." After they graduate, nearly all students will pay off their debts gradually, although they may have to live frugally in order to do so. A pessimist views student debt as likely to be a permanent drain on taxpayers, as upwards of 40 per cent of borrowers will ultimately default on their loans or die before paying them off. Meanwhile the portfolio of federal student loans will continue to grow.
This pessimistic prognosis for student loans rests on the assumption that loans were often given to the wrong students for the wrong reasons and still are. Pessimists believe that the existing student loan program has become unsustainable, as the subprime mortgage lending program was unsustainable, because of imprudent risks. The risks were imprudent because of two main misunderstandings:
- The misunderstanding many students have of the difference between grants, such as Pell grants, which are taxpayer gifts awarded to college students who can demonstrate financial need, and loans, which must eventually be repaid – with interest. Contributing to this misunderstanding is that both types of federal financial aid are funneled though campus departments usually called "Office of Financial Aid." These offices assemble for students a financial "package" covering current college expenses including parental contributions, student earnings, grants, and loans. The time when repayment of the loans must begin is nine months after graduation – for many students, in the almost unimaginable future. Students didn't realize that the burden of large student loans could be justified only if they have a realistic chance of high future earnings from employment.
- The misunderstanding that most parents and politicians have about higher education as an investment in future careers. Many students regard a college education that way also, but for a large minority of students college is not investment but consumption: four fun-filled years before they have to settle down to a life of adult drudgery. That is why many enroll in courses they hear are easy, fail to do the required reading, and come late to class and leave early when they attend the class at all. For such students, college is a time-out or in the words of psychiatrist Erik Erikson, a "psychosocial moratorium." Do students, parents, and lawmakers really want students to incur burdensome loans that must be repaid later – or defaulted on -- to finance a psychosocial moratorium?
Is the High Default Rate a Virtue?
True, it is not possible to predict precisely which students are likely to repay their student loans and how quickly they can do it. But ignoring the likelihood of students being able to repay their loans invites similar problems to those attributable -- at least partly -- to bankers who did not require applicants for mortgage loans to make down payments, have good credit histories, and produce evidence of earnings from employment. What evidence is there that bankers are capable of distinguishing students likely to pay up from students likely to default? The most compelling evidence is the much lower default rate of private bank loans to students compared with federally guaranteed student loans. After all, the history of banking – and the profitably of most banks – attests to the ability of loan officers to distinguish good risks from bad ones.
This lower default rate of private student loans does not impress liberals. Liberals regard the higher default rate of the federal student-loan program as a virtue. What the Department of Education does now is to give loans to every college student who demonstrates financial need without examining evidence of academic ability and other criteria of credit-worthiness. From the liberal standpoint, this policy provides crucial educational opportunities to young people from low-income families. Liberals are willing to have taxpayers pay for the higher default rate in exchange for the increased educational opportunities for children from low-income families. This policy position recalls the first part of the trillion-dollar misunderstanding: the confusion of grants and loans. Children from low-income families already receive Pell grants as well as other need-based scholarships that do not require evidence of superior academic performance. In 2009-2010 Congress appropriated $25.3 billion for Pell grants for 7.74 million American students. True, the maximum grant was only $5,350 per year and the average grant $3,646, not enough for the rising tuition rates at the most colleges and universities. Keep in mind though that these are taxpayer gifts that do not have to be repaid, and the Pell grant program has been an expensive drain on the budget and continues to grow. For 2010–2011 Congress appropriated $32.9 billion for 8.87 million American students; the average grant had risen to $4,115 and the maximum grant to $5,550. However, Congress established a loan program in addition to the grant program because it seemed politically untenable to provide grants large enough to cover the educational expenses of the millions of students who wanted to attend college regardless of their intellectual abilities. The logic of loans was to give students partial responsibility for the cost of their post-secondary educations. It was only partial responsibiity, however, because federal guarantees of repayment of the loans made taxpayers ultimately responsible.
The three possible approaches to the student loan problem are as follows:
- Turn all the loans into grants so that taxpayers rather than students are responsible for repayment.
- Continue to provide student loans to all students who demonstrate financial need regardless of whether or not many default – thus allowing similar disadvantages both to students and taxpayers as happened with subprime mortgages.
- Insert a risk-assessment component into all future student loans that includes past academic performance in order to maximize the likelihood of loan repayment and minimize defaults that add to the national debt.
Possibility 1 is unlikely to attract the support of the voting public and therefore of Congress or even of President Obama in view of current concerns with budget deficits and the overhang of the large national debt. Possibility 2 is almost as bad; the trillion dollar accumulation of student debt will grow and the rate of defaults is expected to increase. That leaves Possibility 3 as America's only chance for keeping student debt under control. The best argument against it is that some students who would ultimately pay back their loans will not receive them because they don't appear to be good risks to the screeners and, on the other hand, that some students who look like good risks to the screeners ultimately default. In short, the human beings who assess the risks of would be student-borrowers, being fallible human beings, make imperfect judgments. Of course, in a decentralized system of loan allocation, students denied a loan in one bank might receive it in another. Although mistakes will be made, the question is: Is a student loan system that attempts to control the risk of default better than one that gives loans promiscuously to all college applicants? Most reasonable voters would say that it is. Moreover, attempting to control the risk of student defaults has another important advantage, as I argued at length in the final chapter of my book, The Lowering of Higher Education in America, published last year: Dangling the prospect of getting needed student loans before students and their parents constitutes an incentive for college students to behave more responsibly. They will be more likely to pay attention in class and do assigned reading, less likely to spend long weekends drunk or on "recreational" drugs, and less likely to accumulate a bad credit rating by maxing out their limits on several credit cards on balances they cannot pay. In short, a side effect of the risk-assessment approach to student loans is to nudge the student cultures of college campuses in the direction of making responsible adult behavior more respectable.
Well, why not?
Jackson Toby is an adjunct scholar at AEI