Discussion: (0 comments)
There are no comments available.
Editor’s note: The next president is in for a rough welcome to the Oval Office given the list of immediate crises and slow-burning policy challenges, both foreign and domestic. What should Washington do? Why should the average American care? We’ve set out to clearly define US strategic interests and provide actionable policy solutions to help the new administration build a 2017 agenda that strengthens American leadership abroad while bolstering prosperity at home.
What to Do: Policy Recommendations for 2017 is an ongoing project from AEI. Click here for access to the complete series, which addresses a wide range of issues from rebuilding America’s military to higher education reform to helping people find work.
Students have become increasingly reliant on student loans as college tuition continues to rise far faster than inflation and family incomes. Much of this increased borrowing has taken place through the federal student loan program, which was responsible for roughly 90 percent of student loans issued in 2015.
Although federal loans dominate student lending, a small private student loan market still exists, comprising roughly 9 percent of the student loans disbursed in 2015. With the rise in delinquencies and defaults on federal loans, along with continued concerns about tuition inflation, some have argued that private student loans should play a larger role in financing students. In theory, private lenders could underwrite loans on the basis of program value—the return students reap for the money they invest—thereby injecting greater market discipline than the federal loan programs, which lend to any accredited program at almost any price.
To assess the likelihood of these predicted benefits, it would be helpful to know more about the criteria that private lenders use today in making loans to students. Specifically, do lenders mainly use traditional underwriting criteria—such as credit scores—that look backward at a student’s prior (and often limited) experience with debt? Or do they look forward to consider how such an investment could transform a student’s earning potential in the future?
To shed light on these questions, this paper employs a mix of data analysis and qualitative interviews with private student lenders and other industry experts. We find that the current private loan market appears to be largely backward-looking, relying on traditional underwriting models to make loans. The likely result is that many students with high potential but a thin credit history and no access to a creditworthy cosigner are not able to get a private loan.
To this point, we find that more than 90 percent of undergraduate loans are cosigned, and low-income borrowers are less likely to rely on private loans than their higher-income peers, even when they face similarly high net prices. Because lenders are underwriting on the basis of cosigner credit rather than student and program characteristics, they may not foster as much market discipline as policymakers might hope.
That said, a growing number of newer lenders—including MPower Financing, Skills Fund, Pave, Climb Credit, and others—are using a wider array of forward-looking criteria such as institutional quality and the likely return on investment of the student’s program of study. While growing quickly, however, these firms are still quite small when compared to existing student lenders.
We identify several factors that discourage lenders from adopting innovative underwriting approaches. Some of these, such as the time it takes to develop investor confidence in new models, are intrinsic to the market. At the same time, there are steps policymakers can take to foster a wider array of forward-looking lending options for students. These include: investigating and clarifying the degree to which fair lending laws may inhibit forward-looking underwriting models; providing additional data to increase transparency around student outcomes; and capping federal PLUS loans to limit risks to students and taxpayers while creating additional space for innovative private lending options to emerge.
Finally, policymakers interested in a more expansive role for private loans should be wary of using generous federal guarantees as a means to achieving that goal. Guarantees reinforce the most significant flaw in the current system: loans are given out with little regard for whether students will be able to pay them back. In contrast, the promise of new forward-looking lenders is that by underwriting based on students’ potential—rather than their background—these organizations can expand opportunity while strengthening market discipline. Greater market discipline, in turn, can foster a system that is more affordable and higher quality.
As the growth in college tuition has far outpaced inflation and family incomes, student loans have become essential to financing higher education for the majority of American students. According to a 2015 analysis by Mark Kantrowitz, 70.9 percent of bachelor’s degree recipients now rely on student loans (federal or private) to help cover the cost of college attendance. This is up from 53.7 percent two decades earlier in 1994. The average debt load of graduates has also jumped markedly over that period, from $17,871 to $35,051 (in constant 2015 dollars), almost a twofold increase.
Students have largely relied on federal student loans to meet their growing financing needs. Under the Federal Direct Loan Program, the Department of Education made $85.7 billion in loans directly to students in 2015; $62.1 billion of those loan dollars went to undergraduates. Before 2010, the federal portfolio also included private student loans guaranteed under the now-defunct Federal Family Education Loan Program (FFELP).
Overall, the federal government disbursed $59.4 billion (in 2014 dollars) in student loans in 2004. That total has increased almost 50 percent since then. Federal loans now represent roughly 90 percent of student loan originations annually.
Despite the dominance of federal loans in student lending, a private student loan market—where banks or other private firms make loans directly to students outside of the federal loan program—still exists. In 2014–15, private lenders issued $9 billion in new student loans, constituting roughly 9 percent of the overall student loan market that year.
These loans are distinct from guaranteed loans made under FFELP, which were essentially federal loans made by private banks. Unlike FFELP loans, private student lenders have full control over terms and are not insulated from default by any federal guarantee. Whereas the federal loan program operates as an entitlement, private lenders set their own lending and underwriting standards designed to maximize their portfolio’s performance.
In response to the explosion in federal student loan debt and consequent rise in default and delinquency rates, some policymakers and researchers on the right have argued that private student loans should play a larger role in financing students. Some make the case that taxpayers cannot continue to shoulder the risk of lending ever-larger amounts—often for programs of dubious educational value—as tuition levels rise at a rapid clip. Others have noted that because the federal loan programs lend money to any high school graduate to attend any accredited college at almost any price, they likely contribute to tuition inflation and prop up low-quality colleges.
Indeed, recent research suggests that increases in the availability of federal loans enable and perhaps encourage colleges to raise their tuition. In theory, private lenders could limit the availability of credit based on program price, quality, and expected earnings. By only lending money to students attending programs where benefits are commensurate to their costs, these private lenders could inject a degree of market discipline that is sorely lacking under the status quo.
These predictions about the benefits of private lending sound great, especially compared to the existing federal student loan mess. But in debating the role of private loans, it is important to look more closely at how the market currently functions, particularly the criteria that private lenders use in making loans to students.
How much do students rely on private lenders in today’s higher education market, and who uses them? Do private lenders underwrite on the basis of traditional measures of creditworthiness—credit scores and the availability of a cosigner (someone who can cover the student’s obligation if he or she fails to repay it)? Or do they include other information about prospective borrowers, such as a student’s choice of institution, field of study, or academic performance? How might existing policies and regulations affect lending behavior? The answers to these questions have implications for debates about how policymakers might create space for private financing to further public goals.
This paper examines these questions with a mix of data analysis and qualitative interviews with lenders and other industry experts. We provide a summary of the existing private student loan market, examine the status quo in underwriting, and take a look at lenders that are experimenting with new underwriting models. We go on to explore the constraints that shape lender behavior in the current market and how those constraints might relate to current policy.
The paper proceeds as follows: the first section discusses different models of underwriting that lenders might employ, importing lessons from other consumer lending sectors. The second section takes a look at the current private lending market using data from the National Postsecondary Student Aid Study (NPSAS) and MeasureOne, a firm that tracks the private student loan industry. The third section draws on a series of interviews with established and emerging lenders to outline current underwriting practices and the forces that shape lender behavior today. The final section concludes with some implications for policy and higher education reform.
There are no comments available.
1789 Massachusetts Avenue, NW, Washington, DC 20036
© 2017 American Enterprise Institute