In the Nation's Interest

What to Do About Growing Student Loan Balances?  Assessing the New College Compact – Part 2

Burgeoning student loan balances have been garnering attention in the media, in Washington, and increasingly on the campaign trail.  And with good reason.  As of the fourth quarter of 2014, the mean balance of student loan debt per person was $26,700, and the median was $14,400.*   These averages are for all Americans of any age who owe money on a student loan, and so they include loans at all stages of repayment as well as loans that parents have taken out to pay for their children’s college.  For the newly graduated class of 2015 the mean balance is estimated to be even higher, at approximately $35,000.   Such large balances create concerns about defaults – at taxpayer expense, since the federal government owns much of the new student loan debt.  Another concern is whether these large student debt burdens are reducing and delaying family formation and home ownership among Millennials.

I’ve written elsewhere about the causes of these ballooning balances, and last week I wrote about the New College Compact’s proposal to make college loan-free.  Today I’ll take up other parts of the New College Compact, and in particular, its proposals around interest rates on student loans.

Lowering Interest Rates on Student Loans: Who Would Benefit?

The New College Compact proposes 1) to allow those currently holding student loan debt to refinance their loans at today’s lower interest rates, and 2) to prohibit the federal government from “profiting” on the interest rate charged to students on future loans.  Although details have not been spelled out, it appears that new borrowers would receive an interest rate that is close to the federal government’s cost of borrowing, which is currently in the range of 0-2% according to CED’s own Joe Minarik.  (What’s less clear is whether the rate offered to new student loan borrowers would be allowed to cover the administrative costs of the loans or a risk premium for the default risk, which can be high, depending on the borrower.  Both factors would push the rate to borrowers higher.)

Interest rates on new federal student loans originating this year range between 4.29% and 6.84%.  Federal loans made directly to students do not begin accruing interest until the student leaves school (although this does not apply to parent loans).ѱ   These are below-market rates, especially when you factor in the non-accrual period.  However, given the federal government’s low cost of borrowing, the government is still apparently “profiting” on these loans.

Lowering the interest rates for new borrowers will definitely reduce the cost of student loans for these individuals.  But will it reduce their overall costs of college?  Some research, including by the New York Federal Reserve, concludes that the greater availability of student loans has mostly benefited colleges, in the form of higher tuition.  The New York Federal Reserve study estimated that colleges raised their posted tuition rate by approximately 65 cents for every additional dollar of subsidized federal loan aid and by approximately 55 cents for every additional dollar of Pell grant aid.  The increases were largest for the most selective private non-profit colleges.  In short, almost two thirds of any new federal loan dollars fuel inflation in college tuition, while only about a third really improves affordability for students.

Of course, all this applies to students currently in college and to tuition now and going forward.  What about the other part of the New College Compact proposal, which would allow those currently paying off student loan balances to refinance at today’s lower interest rates? (Presumably these would be the current 4.29% to 6.84% rates and not the even-lower “government cost of borrowing” rates, since the proposal makes a point of distinguishing between new borrowers and the holders of existing loans.)  The opportunity to refinance at current rates would certainly reduce debt burdens on those holding higher interest loans.  The benefit would be greatest for those currently paying the highest rates, which tend to be private loans.  Again, details are scant, but it is not clear whether all student loan borrowers or only those with federal student loans would be allowed to refinance in this way.  If all student loan borrowers, including those currently holding private loans, were allowed to refinance, it would increase the amount of student loan balances owned by the federal government, which now stand at close to $900 billion.  Taxpayers are on the hook for any defaults on these loans, so further increasing the amount owned by the federal government would increase the risk and potential cost to taxpayers.

Requiring Colleges to Have More “Skin in the Game”

Under current rules, colleges receive the proceeds from student loans, but the cost of default falls on taxpayers (at least for federal student loans).  This, understandably, has created incentives for “bad actors” in the sector to enroll as many students as possible, without regard to whether the students will complete their degree or ever earn enough to repay their loans.  One of the positive elements of the New College Compact is that it would require colleges to have more “skin in the game” in the sense that colleges whose students have low loan repayment rates would be required to contribute to a fund that supports colleges serving a high proportion of low- and moderate-income students.

But returning to the law of unintended consequences, “risk-sharing” rules of this type might, perversely, encourage colleges to cherry pick – that is, to selectively enroll only those students who are likely to repay their loans.  And those students tend to come disproportionately from more affluent backgrounds.  Still, it’s generally a good thing for anyone who benefits from an arrangement to also bear some of the risk when things go south.  Hopefully colleges would be able to distinguish between low-income applicants who are likely to complete and benefit from college (in the form of higher earnings) and those who would not, and not exclude the former.

Things We Like About the New College Compact

Greater transparency and availability of information: Markets don’t function well without widely available and easily understood information.  We at CED have always been big fans of increasing the availability and accessibility of information.  The New College Compact would require colleges to provide greater transparency about graduation rates, the likely earnings and debt of their graduates, and how these compare to other schools – all important factors for families to consider in making their decisions.

Simplifying the FAFSA form: FAFSA stands for the Free Application for Federal Student Aid, and anyone who is applying for college financial aid has had the pleasure of filling one out.  The New College Compact would require FAFSA simplification, which will reduce the number of families giving up in frustration.  The danger, of course, is that by collecting less information, the ability of colleges (and others) to make fine-grained distinctions regarding the ability to pay of various students will be diminished.  But on the whole, simplification is probably a good thing.  Consideration should also be given to ways in which collection of the FAFSA data can be automated or simplified,††  such as the HR Block experiments, where the tax preparation service automatically fills out the FAFSA for low-income families with college-age students based on their 1040 form.  The experiment increased college attendance among participants by 29%.  Despite these impressive results that can be achieved at low cost, the program has not been widely implemented.

Encouraging innovation: To meet the challenges facing the U.S. in the 21st century, colleges will need to educate more students, to higher levels of performance, at lower cost per student.  Fortunately, there is much room for innovation, given that much of our model for delivering postsecondary education dates to the early 1900s or earlier.  The New College Compact has two provisions to reduce barriers to innovation.  First, it would allow the federal Department of Education to pursue more experiments that allow postsecondary students taking some types of online courses to draw federal financial aid.  Second, it would change college accreditation rules to make it easier for new programs and innovative modes of delivery to become accredited.  These new accreditation rules would enforce “rigorous” standards based on outcomes.

Any changes that involve greater use of true experiments and increased focus on meaningful outcomes, like student learning, rather than our current input-focused approach are to be applauded.  That said, we probably should be somewhat skeptical about the federal government’s ability to be an engine of innovation in the postsecondary sector: the federal government just doesn’t move very quickly or nimbly.  Consider the lack of action on the Obama administration’s competency-based education initiative, which was announced over two years ago.  True innovation in postsecondary education is most likely to arise from other sources.  To the extent that government (at all levels) can get out of the way and let it happen (rather than protecting those who stand to lose market share from the changes), then students, employers, and the general public are all likely to gain.

So summarizing across this and my previous post, there are some elements to like in the New College Compact – namely, greater transparency, greater focus on outcomes and innovation, and requiring colleges to have more skin in the game.  But the Compact’s main components, related to “loan-free tuition” and student loans, do not address the true underlying causes of our college affordability crisis and may actually worsen the problem.

-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

* When the mean is significantly higher than the median, this indicates that at the high end of the distribution there are a large number of very high loan balances that are pulling the mean upward.

† Note that the $35,000 figure represents what graduates of the class of 2015 owed before they started paying off their student loans, whereas the $26,700 figure represents individuals at all stages of paying off their loans.

‡ Interestingly, student loan debt is not just an issue for those in their 20s and 30s.  Over a third of student loan debt is held by individuals over the age of 40.  Indications are that much of it was originated when the borrower was 40 or older, suggesting that it went either to pay for their children’s undergraduate or graduate education or their own retraining.  In either case, it carries interesting implications for the retirement assets of these older borrowers. 

ѱ Full disclosure: I am intimately familiar with these rates, having a daughter who is taking out loans this year!

†† Again, my personal experience was that it was not the amount of information gathered by the FAFSA that was difficult.  It was the clunkiness of the federal government website that was frustrating.