Public versus Private Student Loans (Michael Simkovic)

John Brooks (Georgetown) and Jonathan Glater (UC Irvine) argue in today’s Los Angeles Times that the Federal Government should raise the borrowing limit on federal student loans so that college students can borrow more from the government and less from private lenders.*

“Banks and other lenders offer so-called private loans, which often have higher interest rates and less flexible repayment terms [than Federal Student loans]. . . Private student loans are usually much more costly for students; a government report from 2012 found interest rates in excess of 16%, and nothing has improved since then. By contrast, the rate on the most widely used federal student loan currently is 4.29%.

[B]ecause federal loan caps have not budged even as tuition has increased, private lending is rising . . . borrowing is going to happen in some form anyway. This is not about whether college is a good investment (although it is), it is about whether students should be forced to take out loans that put them at greater risk of repayment difficulty and possible default.”

Brooks and Glater have effectively framed the student loan debate.  Federal Student loan policy is not a question of how much students should be allowed to borrow, but rather only a question of who they should borrow from, how much they should pay, and when they should pay.  Any government imposed loan limit is the point at which the borrowers will shift to expensive private sources of credit. 

In other words, private student lenders have a strong incentive to scale back public student loan programs.  The less available and less generous public programs become, the larger the market opportunity for private lenders.  (It is possible that higher or lower interest rates could affect the amount that students ultimately borrow—i.e., the quantity of credit demanded may respond to the price of credit—but Brooks and Glater are clearly correct that a federal student loan limit is not a hard cap on borrowing). 

The idea that increases in federal student loan availability or other public higher education funding programs will increase tuition is sometimes called the “Bennett Hypothesis,” and those who wish to scale back public investment in higher education frequently tout it.  However, there is little evidence in the peer-reviewed literature that increases in the availability of public student loans drive up tuition net of scholarships and grants at non-profit and public institutions of higher education (there is some evidence that this might be the case at for-profit trade schools).  The evidence of harm to students is even slimmer when one considers the potential benefits of tuition increases, which can fund better instruction, better administrative support, more modern facilities, and more generous scholarships, and the possible role of public funding in increasing enrollment and completion rates. By contrast, higher interest payments will generally only benefit student lenders, unless higher rates convey useful information about risk to which students respond. For a review of the literature, see here and here.**

Those advocating scaling back federal student loans argue that it is theoretically possible that income based repayment with debt forgiveness could lead to an explosion of tuition growth because, for some students, the marginal cost of additional borrowing will be zero and these students will not be price sensitive.  (See here) 

However, federal student loan critics have not shown that the introduction of IBR with debt forgiveness, or changes to the terms of these programs, has actually affected the rate of tuition increase net scholarships and grants.  (Indeed, tuition increases, less scholarship, have been relatively mild in recent years).  And this is not surprising—most students do not know in advance whether they will need or qualify for debt forgiveness, and will not know for sure until 10 or 20 years after they graduate.  Most of them will likely ultimately repay their loans in full.  Ex ante and in expectation—when they are shopping for a college or professional school—student borrowers do not face zero marginal cost. 

Similarly, think tank arguments about high costs to taxpayers from income-based repayment and debt forgiveness rely on dubious assumptions such as:

1. Starting salaries for recent college and professional school graduates will grow at an extremely low rate (much lower than one could reasonably forecast after examining the historical data)
2. Every single dollar of debt forgiveness is a cost of the debt forgiveness program, because if not for debt forgiveness programs, no borrower would ever fail to repay their loans and the government would collect every last dollar on time
3. A loan in which the government recoups partial payments with a present value exceeding the amount of the original loan is not a profitable loan; it’s actually a loss
4. The cost of lending $100,000 and receiving partial payments over the next 10 or 20 years is somehow much higher to the government than the cost of giving away $100,000 today and receiving no payments in return (this is related to assumptions 2 and 3 above, as well as  inappropriate uses of discount rates and growth rates).
5. Income based repayment plans have no impact on enrollment and provide no benefits to the government in the form of a more educated workforce that pays higher taxes and depends less on taxpayer funded social services

* Brooks and Glater also praise income based repayment plans as a progressive-income-tax-like system of higher education finance in which those who earn more pay more.  These arguments will be familiar to those who have followed Brooks and Glater’s research. (here  and here)

**The Wall Street Journal publicized a recent working paper that claims to have found a possible link between federal student loan availability and tuition growth at undergraduate institutions. While some of the nuance may not have been reflected in the WSJ's coverage, the authors of that working paper note that: (1) They do not have good data that can distinguish an increase in borrowing from a shift between public and private loans; (2) They are only looking at sticker tuition, not actual tuition paid less scholarship and grants; (3) There are many ways in which public funding can benefit students even if it does increase sticker tuition; and their findings do not demonstrate that public funding is a harmful policy; (4) Variables omitted from their analyses could be driving tuition increases and introduction of additional controls dramatically changes their results.