Resident Scholar Frederick M. Hess

Clearly you see the structure of the student loan system as obsolete. In a major overhaul of the program, what would be the role of the Federal Family Education Loan program? What about the William D. Ford direct lending program?

In restructuring student lending, it is necessary to rethink the FFEL program so that it is better directed toward its original aims of ensuring access to higher education. Eligibility for the FFEL program, when it was established by the Higher Education Act of 1965, was initially limited to low-income students. Yet expansions in the federal loan program since the 1970s have primarily called upon taxpayers to help subsidize college choice and cash flow management for families without demonstrated need. The Middle Income Student Assistance Act (MISAA) of 1978 removed the income cap on loan eligibility. In 1980, the Parental Loans for Undergraduate Students (PLUS) program began allowing parents to take out additional, separate loans under the Stafford program, with no restrictions on family income. Harvard University's Bridget Terry Long has calculated that in 2003-04, nearly one in three dependent students from the highest income quartile took out Stafford loans and borrowed just as much on average as students from the lowest income quartile.

The rationale in creating the Direct Lending Program in 1993 was that, by bypassing private lenders, the process would be simpler for students and less expensive for taxpayers. Nonetheless, history suggests that government-run industries cannot replicate the messy but invaluable processes of innovation and experimentation, and their positive long-term effect on efficiency. That is the real reason for questioning the merits of direct lending--not squabbles over how to score budgetary costs but the concern that government-administered programs are ultimately less likely to yield cost-effective and user-friendly systems than are the alternatives.

You dislike the provision in the College Cost Reduction and Access Act that halves the interest rate on subsidized Stafford loans. Do you view this as simply exchanging one subsidy (provided to lenders) for another (provided to borrowers)?

The aim ought not be to redirect subsidies from borrowers to lenders but to rethink the policy design more fundamentally now that we have succeeded handsomely in establishing a vibrant student loan marketplace. The move to cut subsidies for lenders is a step in the right direction, but additional subsidies for borrowers are unnecessary. In the 1960s and '70s, policy makers assumed that banks would be reluctant to provide the necessary funds to students who are mobile, small-dollar, and risky borrowers, and thought it necessary to provide resources and incentives to ensure an adequate financing pool.

In response, Uncle Sam promised to reimburse lenders for defaulted loans, raised the statutory interest rate, provided a supplemental rate of return for lenders (called the “special allowance”), and created the Student Loan Marketing Association (known as Sallie Mae) to buy extant loans, thereby creating liquidity for new loans. Those efforts have succeeded to a degree that their early architects could scarcely have imagined. Private student lending has exploded to over $17 billion a year, equal to about 25 percent of the federal loan volume, suggesting that those early efforts and developments in credit markets have met many of their goals--at least for serving some segments of student borrowers.

The original subsidies are no longer necessary for the function of the student loan market. In halving interest rates on Stafford loans, the College Cost Reduction and Access Act further subsidized an already competitive interest rate of 6.8 percent. In doing so, policymakers funneled federal dollars toward aid programs that do not effectively target students who are in the most need.

You have made the argument that the federal role in student lending has evolved to much more than helping students afford college--you say it is now helping them ensure they can attend the college of their choice. Is the federal government subsidizing loans for too many students? Should only the neediest (those who qualify for the Perkins program, for example) qualify for a federally subsidized and guaranteed loan?

Almost any formula for determining federal aid in a nation where two to three million students graduate from high school each year will be a poor fit for some particular families and will fail to account for real world situations. Some who qualify for the Perkins program would not need aid and some who do not qualify will need aid. However, the needs of more students could be met if we focus on need rather than using taxpayer dollars to subsidize personal choices.

Providing access to a college education for needy students and using public funds to allow students to attend whatever institution they so choose, however much it costs, are two different things. Average tuition and fees at a four-year public institution is less than $6,000 per year. Meanwhile, tuition and fees at a four-year private institution averages more than $22,000 per year and average tuition and fees at many of the top-tier universities exceeds $40,000 a year. Federal loan programs were intended to ensure that all qualified students are able to pursue postsecondary education--not for taxpayers to help ensure that students can attend whatever institution they find alluring. Particularly given the scant evidence that pricier institutions actually educate more effectively than less expensive, state-supported institutions and the reality that many of the benefits of attending private or out-of-state institutions are related to lifestyle, social life, surroundings, or amenities, it's not obvious to me that we ought to ask taxpayers (most of whom have never graduated from college themselves) to subsidize institutional choice.

I do not believe it is unreasonable to ask students, especially those who choose to attend private or out-of-state public institutions, to take 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.

You have said that private lenders can take the lead in making loans to students who want to attend more expensive colleges. Clearly private lenders already have a large chunk of the marketplace. Do you think all these private loans are made to students who simply want to attend more elite schools? So often, the argument is made that students must turn to private lenders because federal lending simply doesn't cover the costs of the typical college experience. Is this is a specious argument?

No, I'm not suggesting that private loans are only used to attend elite schools. It's obviously the case that some students take out private loans because federal loan limits preclude them from borrowing the full amount they need to meet the costs of tuition and fees. In Footing the Tuition Bill, for instance, Christopher Mazzeo points out that 16 percent of borrowers (less than 2 percent of students) take out the maximum amount in Stafford loans and also take out private loans. However, Mazzeo notes that there has also been a significant portion of the student population who turn to private lenders without maxing out federal amounts. This may mean that students are turning to private loans simply because they are more accessible and customer friendly. It may mean that students are not aware of the options that are open to them. These are all questions deserving further research, but it does suggest some caution is due when regarding claims that the growth of private loans reflects a failure to provide enough federally subsidized lending.

You favor the general concept of income-contingent loans, although you are not completely satisfied with the income-contingent structure in the College Cost Reduction and Access Act. Please explain a better way to issue income-contingent loans.

The income-contingent loan program included in the CCRAA states that loan repayments can be forgiven after 25 years if the borrower faces economic hardship and that repayments will not exceed 15 percent of a student's discretionary income. I am not in favor of writing models into statute. Rather than debate an optimal formula, we ought to encourage lenders to provide and test various approaches, which would create an opportunity to see which models are most useful for different populations and for different needs.

The CCRAA's inclusion of income-contingent loans is a promising step for remodeling the student lending market. Graduates are likely to earn more ten years after graduation than when their repayments start immediately after graduation. Furthermore, students who enter public service careers like teaching will earn modest salaries in comparison to their peers who land high-paying jobs. Income-contingent loans will allow payments to adapt to an individual student's salary over time and will also allow those students with high salaries to compensate for those who enter professions with lower salaries. Yet, I'm uncomfortable with settling on an “ideal” model or enshrining it into law. I think there are a variety of reasonable approaches to this question that other nations, including Australia and New Zealand, have pioneered. We ought to create room in the lending system for various approaches to be developed and to evolve as circumstances dictate.

Is it a concern that many (if not most) borrowers feel the interest rates charged by private student lenders are too high? Under what scenario could market forces take over to prompt lower interest rates? Would private rates ever be as low as those available in the FFEL program?

Sure, it's is a concern. However, the reason that interest rates are lower under the FFEL program is because they are subsidized by taxpayers. If the FFEL program provides loans to students who attend pricier institutions, these subsidies may come from taxpayers who are less well-off than the students receiving them. Rather than assuming that the goal of policy should be to provide the lowest possible interest rates, we ought to focus on crafting a system that provides for students with demonstrated need, that addresses issues of access and affordability and that fosters new solutions to familiar problems. For instance, while interest rates for private loans are higher than those for loans subsidized by the federal government, private loans have the agility to innovate and provide alternative repayment options. 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 students, a variety of repayment terms and timelines and user-friendly websites. The Bank of Ireland offers no-interest loans to undergraduates in medical fields. The U.S.-based 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 “pre-prime” borrowers--students with potential who have not yet established credit histories and have no cosigners.

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