A young couple with modest earnings can buy a house that costs many times their combined incomes without putting down more than a small fraction of the cost, as long as they have reasonably stable employment and a decent credit history. They pay a market-determined interest rate to the lender that is presently about 6 per cent in the United States for a 30 year fixed rate loan. However, it is crucial that they offer their home as collateral, so that the lender can repossess it if they fail to meet their mortgage payments. They can borrow to purchase a car too, essentially by offering the car as collateral.
Yet with the exception of medical and a few other types of students, young persons cannot borrow on a purely commercial basis without parental or other co-signers to finance their higher education. The usual explanation has been that unlike homes and other consumer goods, education cannot be offered as collateral to guarantee repayment. This means that in the event of defaults on student loans, there would be no assets for lenders to repossess. Put differently, lenders cannot take ownership of the human capital they finance since that means taking ownership of the individuals receiving the education, and no modern country allows people or institutions to own other individuals. Still, even without such collateral, it is possible to encourage a fully commercial student loan market with a few straightforward changes.
Countries typically help students by paying most of the direct costs of higher education, and also sometimes by providing scholarships to help pay for the cost of living while in school. Though the stated reason for this is to allow poorer students access to higher education, the beneficiaries are mainly children from the middle and upper classes since they are the ones who attend these mainly state-run colleges and universities. Even in the Unites States, about 80% of all students are enrolled in subsidized state-run institutions. This system penalizes less prosperous families who do not have children at universities and colleges, but are nevertheless taxed to help support the education of children from richer families. Even children from modest backgrounds who do manage to get a university education tend to become part of the economic elite.
In order to provide a better way to support students, or at least a way that complements direct subsidies, the United States about 40 years ago introduced a system of loans for college students that would be repaid gradually after they finish their schooling and are working. Similar systems have been introduced in a few other nations. To encourage private lending, the federal government guarantees repayment of defaulted principal and interest. The program has grown rapidly, so that the value of student loans outstanding has increased to over $400 billion. The current interest rate on new loans is about 31/2% (it is regulated and tied to short term interest rates). Interest rates on student loans are well below rates on mortgages, credit cards, and other sources of consumer credit mainly because the federal government rather than lending institutions bears the burden of defaults.
By the early 1990’s this burden became great indeed, as defaults on student loans ballooned to over 20 per cent. No commercial loan system would be viable with these default rates at the low interest rates allowed. Partly because wealthy lawyers and doctors allegedly were responsible for significant numbers of these defaults, politicians pushed for tougher enforcement. A 1998 law made it very difficult to discharge student loans by declaring personal bankruptcy- a privilege not available to credit card companies and many other lenders to consumers- the federal government began aggressively using private agencies to collect defaulted interest and principal on student loans, and these agencies could garnish significant fractions of the earnings of borrowers in arrears on their debt. As a result, default rates have plummeted to about 5%. They are in fact relatively low among graduates of professional schools and elite colleges, and are highest- among persons who had attended community colleges and trade schools.
Loans to finance education (and other investments in human capital) are a good idea, but why should the federal government subsidize them? College education raises earnings and improves health and many other aspects of living. Since these effects are huge and even larger than a few decades ago, loans to finance education should be attractive even without subsidies. It is especially inappropriate to subsidize loans to students coming from middle class and wealthy families who can expect very high earning over their lifetimes. Some writers lament the burden of large student loans, but even $100,000 in student loans is easier to repay than $150,000 in mortgages, a burden that many young families are clearly willing to bear.
Private lending institutions would be willing to make student loans without government subsidies at interest rates that I believe would not be much higher than mortgage rates if certain conditions were met that already apply to government subsidized student loans. The most important are that commercial student loans should be hard to discharge by declaring personal bankruptcy, that collectors could garnish a reasonable share of earnings in the event of defaults, and that interest on student loans could be deducted from taxable income.
Originators of student loans-Sallie Mae and another private institutions-typically repackage them, and sell them in a secondary market, similar to the way mortgages are repackaged and sold. So the “securitization” of student loans is a reality. What is needed to have a well functioning and extensive private commercial market in student loans are the various privileges already available to government-backed student loans that help overcome the absence of collateral when making loans for education. In addition, since education is an investment in human capital, the amount students invest- perhaps measured to start by the amount they borrowed to finance their education- should also be deductible over time from their taxable incomes, the way corporations can deduct the cost of capital from their tax liabilities.
A private commercial market in student loans under these conditions would not need government subsidies, and would have the flexibility to develop new contractual forms. These might include the often-suggested system whereby interest rates on student loans would not be fixed, but would rise with the eventual earnings of borrowers. Other innovations would emerge as freer and more imaginative competition in the market for student loans developed. It is surely time to rethink the conclusion by economists that commercial loans on education are not feasible because education capital cannot be used as collateral.