The Student-Loan System Needs a Major Overhaul

Resident Scholar Frederick M. Hess
Resident Scholar
Frederick M. Hess

This month, Congress voted to cut subsidies to lenders in the federal guaranteed-student-loan program and use much of the savings to increase student aid. Following a hectic summer of activity concerning college financing and affordability, Congress also passed other significant provisions--including modified repayment periods and loan forgiveness for certain students.

That burst of legislative action came on the heels of New York Attorney General Andrew M. Cuomo's high-profile investigations into student lenders and their partnerships with colleges, and his call for new codes of conduct to govern those relationships.

Both Congress and Cuomo deserve credit for dealing with some of the challenges and excesses of the student-loan machinery. But more must be done to overhaul an outdated and overburdened system that needs a thorough redesign.

Today more than half of the population pursues postsecondary education, and an estimated 60 percent of new American jobs call for a college degree.

In the late 1960s and 70s, fearing that banks would be reluctant to offer loans to mobile, financially high-risk students whose loan amounts would be comparatively small, federal policy makers sought to nurture a viable student-loan industry. Today a private loan industry is thriving, and federal efforts to make lending more appealing are less necessary.

Increased Demand for Higher Education

Indeed, times have changed drastically since the passage of the initial Higher Education Act, in 1965. Fifty years ago, before that act, just 15 percent of the adult population pursued higher education, and only 15 percent of new American jobs were thought to require it. It was within that context that Congress passed the act, to build on the legacy of the GI Bill of Rights of 1944 and make loans more widely available to a limited population of low-income students.
Today, however, more than half of the population pursues postsecondary education, and an estimated 60 percent of new American jobs call for a college degree.

At the same time, the explosion in the numbers of nontraditional students and the popularity of distance learning and for-profit institutions have created a fundamentally different demand for education. Lifelong learning is becoming a requirement for growing numbers of professionals; enrollment of students 25 and older increased 19 percent between 1990 and 2005 and is projected to climb an additional 18 percent between 2005 and 2015.

In short, a college education has morphed from a luxury good into a crucial gateway for a satisfying working life. What has remained unchanged is the student-aid system.

From College Access to College Choice

The original Higher Education Act sought to provide college access to needy students. Over time it has been transformed into a program that increasingly subsidizes college choice. That is a huge difference.

Consider that annual tuition and fees at a four-year private college averaged more than $20,000 last year; they averaged less than $6,000 at a four-year public institution. Yet students seek, and qualify for, federal aid to attend whatever college they select. Surely it is not unreasonable to ask students, especially those who choose to attend private or out-of-state public institutions, to shoulder some of the financial responsibility for an education that will deliver each of them roughly $1-million in additional earnings in the course of their working lives.

Thus Congress and Attorney General Cuomo are taking incremental steps to increase transparency and level the playing field for students. But much more is needed. At least six steps deserve consideration:

Reassessing federal subsidies and guarantees. We applaud Congress's move to reduce subsidies to lenders and provide more Pell Grant money for low-income students. We are disappointed, however, by the crowd-pleasing decision to halve borrowers' interest rate, a move that asks taxpayers to underwrite an enhanced, largely indiscriminate and across-the-board subsidy.

According to Richard George, a former director of the National Council of Higher Education Loan Programs, more than 60 percent of the cost of the federal Title IV loan programs consists of special-allowance payments for lenders and interest subsidies for borrowers. Those only improve an already competitive rate for middle-class students. Providing access to a college education for needy students and using public funds to allow students to attend any institution they choose, however expensive, are two quite different matters.

Private loans, made without federal support or subsidy, now represent 20 percent of the student-lending market. Private lenders can take the lead in underwriting loans for students who desire to attend pricier colleges and universities.

Although it is important to ensure that private lenders don't use deceptive marketing to entice students into debt that they are unprepared to handle, such lenders have the agility and incentive to experiment with pricing and repayment options that may be cheaper, more convenient, and more customized than what's available today.

Important innovations have been pioneered by private lenders or have resulted from the competition that they have introduced: discounts for timely repayment, more options for part-time and nontraditional students, a variety of repayment terms and timelines, and user-friendly Web sites.

The Bank of Ireland, for instance, offers no-interest loans to undergraduates in medical fields. In this country, MyRichUncle is attempting to build a proprietary model that uses the earnings of alumni from various institutions, starting salaries in various fields, students' grade-point averages, and extracurricular activities to identify “PrePrime” borrowers--students with potential who have not yet established credit histories and have no cosigners.

Expanding income-contingent loans. Congress has also voted to expand income-contingent repayments on loans, which would limit payments to 15 percent of a borrower's discretionary income and forgive loans after 25 years.

The long-term goal should be the development of a variety of income-contingent arrangements that yield repayment models more attuned to different students' earnings trajectories after they graduate.

We are skeptical of efforts to arbitrarily legislate the 15-percent and 25-year standards and of the suggestion that those percentages and numbers are somehow optimal. But we applaud the effort to expand the use of income-contingent lending. After all, a student debt of $25,000 is far more burdensome for new graduates than for those who are 10 years out of college, and for graduates who take relatively low-paying jobs in public service than for their peers who land high-paying jobs.

The long-term goal should be the development of a variety of income-contingent arrangements that yield repayment models more attuned to different students' earnings trajectories after they graduate. In Australia, for instance, loan repayment is 4 percent to 8 percent of income and is calculated on an income-based sliding scale. In Britain repayment is 9 percent of income above a minimum annual level.

Streamlining the financial-aid application. There is broad bipartisan agreement on the need to retool the Free Application for Federal Student Aid and render the entire lending system more user-friendly.

Susan M. Dynarski, an associate professor of public policy at Harvard University, and Judith E. Scott-Clayton, a doctoral fellow in public policy there, have argued that a total of only about a dozen questions could nearly duplicate the results of today's sprawling form, while easing the burden on everyone involved. Families intimidated by the length and complexity of the required paperwork for government-sponsored loans, or those who today opt for more-expensive private loans purely out of convenience, would be better able to concentrate on costs, benefits, and repayment terms.

Re-evaluating the HOPE and Lifetime Learning tax credits. Such tax breaks were intended to make college more affordable and increase enrollment. But they are useful only to families with incomes high enough to benefit from them. Also, the credits are claimed on the following year's tax return, so they help only those who already have the money in hand to pay for college.

Congress should redirect the $5-billion spent on the credits to Pell Grants, a move that could increase the maximum grant by close to $1,500 per year. Combined with Congress's recent increase of the grants from $4,050 in 2006 to $5,400 over the next five years, that would allow the Pell Grant to cover up to $6,900 of college costs for a low-income student--an amount that surpasses tuition and fees at the average four-year public institution.

Such a move would overturn decades of gradual erosion in the purchasing power of the Pell Grant, and allow the program to once again fulfill its promise that cost will not bar qualified students from having access to college.

Making loan originators more responsible for their loans. Today, just as in the mortgage market, loan originators package the bulk of student loans and resell them to third-party companies. Although that significantly increases liquidity and loan availability, the process protects the originators from any risk and can encourage them to be less prudent in making loans.
In the housing sector's continuing sub-prime-mortgage debacle, we have seen how such development can encourage originators to issue questionable loans and borrowers to get in over their heads. Requiring loan originators to adopt a portion of the risk could help align incentives more sensibly.

For instance, institutions with high default rates might be penalized in federal-support formulas and in competitions for other federal grant aid. Or the government might require that colleges whose financial-aid offices administer a volume of loans in excess of a given threshold be required to retain or purchase a specified percentage of those loans. Institutions with large endowments might be expected to do that as part of their portfolios; the state could be allowed or encouraged to do it on behalf of public institutions.

The Education Department could convene a group of financial experts and higher-education officials to discuss ways to manage risk and create healthy incentives for colleges and investors. At the same time, any innovation should be devised with sufficient attention to possible adverse consequences.

It has been the preferred-lending lists, created under pressure from the federal government to police default rates, that have given rise to many of the current lending scandals. The aim should be to ensure that all interested parties have a stake in timely loan repayments and in ensuring the soundness of lending decisions.

Improving the training and evaluation of financial-aid officers. To avoid the problems that the housing industry experienced, as well as those that Cuomo uncovered in student-lending practices, policy makers should also insist on more readily available information about financial-aid offices, including codes of conduct, years of experience, and relationships with preferred lenders--including how they are chosen.

In addition, they should encourage the creation of independent ombudsmen who can give students information about an institution's student-default rate and compare its loan options with those negotiated at similar colleges.

Historically, financial-aid officers, usually overlooked and left to their own devices, administered small, standardized programs. Now those administrators must adjust to the increasing presence of private lenders, direct marketing, and competing and complex loan products and services.
They will have the opportunity to negotiate more creatively with lenders and pioneer new ways of reaching out to student borrowers, but they will need help as they redefine their roles.

Colleges and universities should rethink how they evaluate and reward the contributions of financial-aid officers, and professional organizations should train financial-aid officers in the knowledge and skills they need to successfully navigate the new student-loan marketplace.

Those are just a few of the steps that should be considered. Ultimately the goal in revising the student-loan system should not be to tweak a once innovative, now outdated, apparatus. We need to reassess the fundamental goal of our student-aid system and to define what we want to put into achieving access, what goes into giving students choice. Then we need leadership that can re-engineer yesterday's creaking handiwork for the challenges and opportunities of the 21st century.

Frederick M. Hess is a resident scholar and director of education policy studies at AEI. Juliet Squire is a research assistant at AEI.

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