Anyone familiar with this website knows that I’m not a fan of the higher education business model. And this isn’t because I want to keep Americans ignorant and easily manipulated by the ruling elite. No, my biggest problem with higher education is this: The odds of you leaving college with minor cognitive gains, lousy job prospects, and unmanageable debt are just as likely as you leaving college with substantial cognitive gains, great job prospects, and no debt. In other words, higher education is no longer a slam dunk path to the middle class and beyond.
My theory is that students loans are responsible for higher education’s fickle ROI. Colleges can only charge $100,000 for a sociology degree because the government promises to put that kind of money in an 18-year-old’s hands via student loans. Take away the student loans and the cost of college would drop precipitously. After all, how can people thrown into a fiscal crisis by a $400 emergency come up with a $100K for a sociology degree or any other kind of bachelor’s degree?
But this is just a theory, of course. I’d readily admit that I’m out of my depth here (i.e., I’m talking out of a certain part of my anatomy below the belt).
To get a better understanding, I asked my blogger friend Drew Cloud over at The Student Loan Report to consider what privatizing student loans might entail. Here’s what Drew had to say.
Should the government privatize the student loan industry? Many in the Trump Administration want to get the federal government out of the direct student loan business. Naysayers, however, fear that the ugly side of the previous privatization era would soon repeat itself if the privateers have their way.
In case you forgot what this ugly side was, let’s take a quick trip down memory lane.
Before the federal government started lending directly to college students, the federal government regulated the loan agreements between banks and students. The federal government guaranteed the student loans made by banks. If any student failed to repay his or her loan, the taxpayers would make the bank whole. And in exchange for this guarantee, the banks had to accept interest rates and borrowing limits set by the federal government.
This arrangement worked well for several decades, but then things started to go awry, especially once the 21st century arrived. The moral hazard of banks having no incentive to forego loans to students attending dubious colleges and students having no incentive to forego colleges with steep costs finally reached a critical mass. Banks and colleges went unscathed when student loan defaults proliferated. Taxpayers and naive college students, however, took a big hit.
Today, the student loan landscape is totally different. About 90% of student loans are now given directly by the federal government. Only those students who still need help paying for college after all scholarships, grants, savings, and federal student loan options have been exhausted turn to banks and private student loans.
The Cons of Student Loan Privatization
Borrowing for college is not the same as borrowing for a car or a home. A student can’t put up his or her future degree as collateral the way a person can put up his or her purchase as collateral for an auto loan or a mortgage. How, after all, is a bank supposed to repossess an education?
Because there is no collateral, banks would have to charge incredibly high interest rates in order to make student loans profitable. Milton Friedman explained this classic case of market failure in a 1955 essay.
[A student loan] necessarily involves much risk. The average expected return may be high, but there is wide variation about the average. Death or physical incapacity is one obvious source of variation but is probably much less important than differences in ability, energy, and good fortune. The result is that if fixed money loans were made, and were secured only by expected future earnings, a considerable fraction would never be repaid. In order to make such loans attractive to lenders, the nominal interest rate charged on all loans would have to be sufficiently high to compensate for the capital losses on the defaulted loans. The high nominal interest rate would both conflict with usury laws and make the loans unattractive to borrowers….
But what if students used their own future income as collateral? Banks would pay higher education costs in exchange for a specific portion of the student’s future income. Would this make privatization feasible?
It might, providing regulations were in place to make sure students didn’t become life-long indentured servants to banks. But again, if the federal government 1) put a reasonable limit on what percentage a bank may claim on a student’s future income (i.e., no more than 10%), and 2) put a reasonable limit on how many years that claim may stretch (i.e., no more than 10), would banks find student loans profitable enough to make them?
Here’s the bottom line. Private student loans aren’t feasible without the federal government guaranteeing repayment (i.e., being an unofficial cosigner) and subsidizing interest rates. The only people who might get student loans in a laissez-faire environment are people with rich parents and people with high IQs pursuing very remunerative majors. Not exactly the recipe for income equality and an upwardly mobile society.
The Pros of Student Loan Privatization
This is a tough one. I really had to rack my brains on this one. As far as I can tell, there are only three pros to student loan privatization. Here they are.
Interest rates and terms. Providing you have very creditworthy cosigners (i.e., rich parents), you will have numerous banks competing for your business. This, in turn, means you will likely come across very attractive interest rates and terms.
Cosigner relief. After repaying my student debt faithfully for several years and raising my credit score significantly, I refinanced my private student loans with a new lender and it allowed me to release my cosigner. This was a big relief for my parents. Their little birdie had officially left the nest.
College costs. If college costs began to outpace a student’s earning potential, banks would stop lending money to students. Private student loans would be a natural check on higher education avarice and greed.
Is Student Loan Privatization Good or Bad?
In my humble opinion, the cons outweigh the good. Sorry Mr. Groovy. Maybe I would think otherwise if I thought student loans were the driver of ever increasing college costs. But I don’t ascribe to that theory.
Let me conclude with this: In order to go to college, I needed both federal and private student loans. After I graduated, I got a job fairly quickly. But servicing my loans was a struggle. Thankfully, my federal student loans had repayment options my private student loans didn’t. I was able, for instance, to use an income-based repayment plan for my federal student loans. And because of this lifeline, I never missed a payment. My credit score and sanity were saved. Had I only had private student loans, however, I would have been screwed. I called my private student loan servicer to see if I could make my payments more manageable, and it grimly told me that I was out of luck. It didn’t have an income-based repayment plan, it only offered deferment if I went back to school, it offered up to twelve months of forbearance but only for three months at a time, and it had no forgiveness options.
I’m not saying the federal student loan program is perfect. It, like most things the federal government does, needs to be tweaked. But it does give everyone a chance to better themselves through college. Private student loans can’t do that. If the federal government got out of the student loan business entirely, college would only be an option for the rich.
Be very wary of student loan privatization.
Mr. Groovy here again. Et tu, Drew?
Haha! All kidding aside, I really appreciate the analysis that Drew provided here. It never quite dawned on me how impractical college would be for millions of Americans if the federal government got completely out of the picture and we only had private student loans to bridge the gap between student means and college costs. Talk about market failure!