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Student Loans for Dummies

Monday, October 24, 2011

Accumulated student loan debt now totals $1 trillion. The Super Committee should fix the student loan program by requiring evidence of ability to repay guaranteed loans.

The Joint Select Committee on Deficit Reduction, the so-called “Super Committee,” is looking for ways to cut $1.2 trillion in deficits over the next decade. In order to achieve this goal, the Super Committee must not overlook a design flaw in the federal student loan program that threatens to blow a huge hole in the federal budget.

The federal government guarantees repayment of most student loans. Therefore, each loan default eventually adds to the deficit. Initially, the cost of defaulted loans was negligible because the federal loan portfolio was small and the majority of graduates were paying loans off. But the rising cost of defaulted student loans is now receiving more attention. The Department of Education announced on September 13 that the overall default rate for federally guaranteed student loans had risen to 8.8 percent for the fiscal year ending on September 30, 2010, up from 7 percent the previous year. This was the highest default rate since 1997.

But 8.8 percent is only the tip of the default iceberg as this number refers only to the 320,000 graduates out of 3.6 million who defaulted within two years of their first payments being due. Four years out will be worse. Longitudinal studies of student borrowers show that defaults peak in the fourth year after payments begin to be required and continue in subsequent decades; estimates are that about 40 percent of student borrowers will default sooner or later.

As with sub-prime mortgages, the Department of Education, Sallie Mae, and banks gave students loans without scrutinizing their ability to repay them. Congress hadn’t asked them to.

The Department of Education does everything it can to prevent students from falling into the default category by postponing the repayment requirement through deferments or forbearance mechanisms. Students also can postpone the repayment requirement by enrolling in graduate or additional undergraduate programs because the repayment requirement begins only when students are out of school. Eventually, however, the student’s only permanent solution to student-loan debt is obtaining a job that pays well enough to start repaying the loan.

By 2011, students and former students had accumulated debts of about $1 trillion on their student loans, more than the total of American credit card debt. Defaults increased in 2011 as a higher proportion of college graduates failed to find jobs.

One reason they can’t find jobs is the weak economy, but it is also partly due to a flaw in the student loan program. As with sub-prime mortgages, the Department of Education, Sallie Mae, and banks gave students loans without scrutinizing their ability to repay them. Congress hadn’t asked them to. This design flaw will lead to larger contributions to the deficit from defaults in future years unless Congress fixes it.

The student-loan default crisis resulted from good intentions. When Congress originally decided to help kids go to college, it provided grants, not loans. These Pell grants give youngsters from low-income families the opportunity to prepare at college for well-paid, interesting careers. In 2009-2010, 7.7 million students received Pell grants at a cost of $28.2 billion (the administrative cost of operating this large program was about $4 billion).

Tightening eligibility for student loans would also create an incentive for high school and college students to behave like adults.

Pell grants added to the deficit in that year but not to future deficits because they do not have to be repaid. Congress limited the maximum size of Pell grants, although it gradually increased that limit as college costs rose. It was $5,350 for the academic year 2009-2010, $5,550 for 2010-2011, and $5,710 for 2011-2012. Limiting the size of Pell grants was politically necessary because bigger grants would have been very expensive.

Congress also established various guaranteed loan programs (beginning with Title IV of the Higher Education Act of 1965) as supplementary student aid for college costs. Loans rather than grants now comprise three-quarters of federal student aid. Student loans must be repaid after graduation or after leaving school without graduating—along with accrued interest—regardless of whether their educations helped former students get jobs.

The flaw in guaranteed student loans was to require only an assessment of economic disadvantage, not the ability to repay the loans; and graduates who major in having fun—as too many college students seem to do today, especially in “party schools”—usually fail to learn enough to get good jobs afterwards.

The Super Committee should recommend that student loans require evidence of ability to repay them by examining students’ academic records, credit histories, and other criteria of credit-worthiness. This change would treat student loans as risky investments and ensure they are given only to student borrowers with a good chance of being able to repay them.

Estimates are that about 40 percent of student borrowers will default sooner or later.

Such a student loan system makes better economic sense than one that gives loans promiscuously to all needy college students. Needy college students are still eligible for Pell and other college grants. Grants do not impose a requirement of credit worthiness.

Tightening eligibility for student loans would also create an incentive for high school and college students to behave like adults. They are more likely to do the assigned reading, less likely to spend long weekends drunk or taking recreational drugs, and less likely to accumulate bad credit ratings by exceeding limits on several credit cards. And it saves taxpayer money, too.  Remember what Senator Everett Dirksen reportedly said, “A billion here and a billion there, and before you know it, we’re talking real money.”

Jackson Toby, professor of sociology emeritus at Rutgers University and an adjunct scholar at the American Enterprise Institute, recently published The Lowering of Higher Education in America.

FURTHER READING: Toby also asks “Incentives Work for Pigeons. Can They Motivate American College Students?” Frederick M. Hess writes “Old School: College's Most Important Trend Is the Rise of the Adult Student,” “Obama's College Confusion,” and “I Owe U.”

Image by Rob Green | Bergman Group

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