Higher-education policy is ripe for innovation. Not only is the Higher Education Act, which authorizes federal student aid, set to expire at the end of the year, but the problem of staggeringly high student-debt levels has finally captured the nation’s attention. However, our elected officials are thinking about the problem of student-loan debt strictly in terms of the choices students can make. That’s why President Obama and Congress are fiddling over the minor issue of student-loan interest rates and ignoring the badly distorted incentives that govern our broken higher-ed system. As a result, many promising avenues for reform are being missed.
Student-loan debt has grown significantly over the past decade, and has doubled in the past five years alone. According to a recent study, the average student-loan debt for the class of 2011 is $26,500. But increased debt levels would not constitute a problem if not for the accompanying repayment trends. Of all types of household debt, student loans are associated with the highest 90-day delinquency rates, a trend that will likely continue due to the increasing number of subprime student borrowers. Default rates are growing as well: The Department of Education found that the three-year default rates for student loans were 7.5 percent at private non-profit institutions, 11 percent at public non-profits, and 22.7 percent at for-profit institutions.
Failing to repay a student loan can have serious consequences. Delinquent borrowers are reported to credit bureaus, which can then lower their credit scores, while defaulting borrowers can have their wages garnished and their tax refunds withheld. Moreover, it is extremely difficult for these borrowers to discharge their debt. Contrary to conventional wisdom, it is possible to discharge student debt in bankruptcy; however, borrowers must prove to a judge that repaying their loans would constitute an “undue hardship.” Only 40 percent of borrowers who make this appeal are successful; only 0.1 percent of borrowers who file for bankruptcy even try.
Why do unwise borrowing trends persist? The most obvious explanation is the unimpeded growth of college tuition. The ever-rising cost of attending college requires students to take on ever-growing debt loads. Additionally, Americans place a high value on higher education even as they increasingly recognize its flaws. A recent Pew poll found that although 57 percent of Americans think our higher-ed system “fails to provide . . . good value” and 75 percent believe it is “too expensive,” 94 percent still hope their children will attend college. The willingness to pay college tuition despite high prices and low returns helps explains why student debt was the only form of household debt to grow during the Great Recession.
Additionally, the federal government encourages unwise borrowing. During the financial crisis, the federal government dramatically increased its spending on federal student loans: Spending increased 19 percent in the 2008–09 academic year and 18 percent in 2009–10. From 2001 to 2012, federal spending on loans increased 120 percent.
Furthermore, the federal loan system insulates colleges from the negative consequences of raising tuition. Consider how students obtain aid: First, colleges determine the cost of attendance (COA) for each student seeking federal aid. Then the financial-aid staff at the student’s college calculates the student’s expected family contribution (EFC), the amount the student’s family is expected to contribute based on the family’s financial background. The financial-aid staff then calculates the student’s need by subtracting the EFC from COA. The school then sums up its students’ total need and makes a request to the federal government. Though there are limits to the amounts individual students can borrow from the federal government, there is no limit to the amounts colleges can receive for eligible students.
Since loan awards are tied to the cost of attendance, colleges can raise tuition with the guarantee that the government will continue lending to their students. The colleges therefore have little incentive to become more efficient by cutting costs. In addition, the federal guarantee to increase funding as tuition increases makes it impossible for students and parents to assess whether the price of a college reflects its value. Accordingly, students and families make unwise investments in higher education.
Policymakers wishing to ease student-loan burdens must therefore focus on getting the incentives right. A revamped student-loan program might separate loan awards from the cost of attendance. The government could offer loans tied to the median cost of attendance at four types of institutions: for-profits, non-profit private schools, public schools, and community colleges. Students would receive the loan award corresponding to the type of institution they chose to attend, rather than the cost of the individual school they select.
This reform would have a salutary effect on both colleges and students. Colleges would no longer have the guarantee that the federal government will factor their tuition increases into loan awards, and would therefore think carefully before raising tuition. Students, who would need to make up the difference between the sector-wide award and the cost of attending a given college, would become more price-sensitive. Accordingly, colleges would need to court students, either by lowering prices or by offering worthwhile educational opportunities. This reform would not have a dramatic effect on the number of students of modest means who can attend elite schools. Students of modest means are already underrepresented at these schools; moreover, these schools typically have large endowments and can offer generous financial-aid packages. The biggest losers in this scheme will be expensive lower- and middle-tier schools, which will struggle to draw talented students of modest means.
A new loan program that brings market pressures to bear on our universities will go a long way toward fixing the distortions created by current federal policy. Policymakers should recognize that fixing our universities’ incentives is the best way to make American higher education less burdensome for all students.
— Judah Bellin is the editorial assistant at Minding the Campus, the online magazine of the Manhattan Institute’s Center for the American University, and author of the new report College Credit: Repairing America’s Unhealthy Relationship with Student Debt.