The student debt situation has improved. A new study reports a substantial drop in the proportion of students with private loans, which are usually a worse deal for students compared with federal government loans. There are important lessons we can learn from the rise and fall of the private student loan market.
For over 40 years there have been two kinds of student loans: federal loans with terms set by Congress, and private loans offered by banks. Confusingly, since 1993, federal student loans have been offered two ways: federal loans directly from the U.S. government, and federal loans provided by private lenders but guaranteed by the government. The terms for these two types of federal loans were identical. In 2010 the federal guarantee system was ended and all federal loans now come only from the government.
Private loans, however, are different from federal loans. Private banks charge higher interest rates because they cannot raise funds cheaper than the government without the federal guarantee. Like other consumer loans, banks also generally set the interest rates based on the borrower’s credit scores. Private lenders frequently charge higher processing fees and are less generous in granting repayment reprieves.
In our report published recently by the National Center for Education Statistics, Dr. Erin Dunlop Velez and I found that the use of private loans rose greatly in the period leading up to the 2008 financial crisis. The percentage of private loan borrowers was nearly three times higher in 2008 than in 2004 before dropping back to the 2004 level by 2012. This pattern held for students at all types of schools, income levels, and for graduate students as well.
The highest proportion of students who borrowed was at private for-profit schools that were 2-years or more. Fourteen percent of undergraduates at these schools took out private loans in 2004, about 41 percent did so in 2008, and then borrowing dropped back down to 12 percent in 2012. Meanwhile federal borrowing by students at all school types steadily increased throughout the period.
We can’t rely on private loans to provide all the lending required in higher education.
There are two valuable lessons here. First, private student loans, like other consumer lending, are subject to the vagaries of the financial markets. The swings in private lending mirrored mortgage lending, rising significantly in the 2004-2008 period. After the financial crisis of 2008, banks tightened student lending standards, requiring proof of enrollment and co-signers on loans. Many banks dropped out of the market entirely. This confirms that the normal standards of underwriting had generally not been in place, making private loans an unreliable source of funds.
Second, we can’t rely on private loans to provide all the lending required in higher education. When funds are available and judicious standards are exercised, the supply of private loans is considerably smaller than the total demand for funds to pay for college. Many talented but low-income borrowers with no credit history and few prospects wouldn’t be extended loans.
We need the federal loan system which doesn’t pick recipients as narrowly as private lenders. It cushions student borrowers who find themselves in trouble due to unpredictable outcomes such as market downturns. And it extends loans to all who want to invest in themselves. Federal loans are available to all students who attend eligible schools. The burden is on the school to monitor borrowing and reduce defaults in order to remain in the federal loan program. The government removes risky schools from the loan program and publishes statistics such as graduation rates, average salaries, and default rates for schools.
There is more that can be done. The government could release more information for all types of schools and programs so that students could better judge whether borrowing is worth it. Federal loan limits could be refined so students don’t borrow excessively and struggle to repay afterwards, or are forced to drop out for lack of funds. Applying stronger incentives to schools to provide accurate information and guidance to their student borrowers would also improve borrowing outcomes. The goal is to extend opportunity to all who seek higher education without saddling them with a lifetime of financial difficulties. Prudent lending is a concept we can all get behind.
As a research education analyst at RTI, Jennie Woo played a key role in several of our large longitudinal studies of postsecondary education.