Picture of Christopher A. Hopkins, CFA

Christopher A. Hopkins, CFA

The student loan mess: proposals for reform

The value of student loans outstanding has doubled over the past decade and now stands at $1.7 trillion, exceeding all other forms of debt except mortgage loans. Many borrowers are precluded from buying a home, and some Americans are even seeing part of their Social Security benefits garnished to pay off college loans. Meanwhile, a substantial cohort that never finished college must pay the piper even though the music stopped.

Last week we traced the evolution of the US higher education funding regime and the explosion in both debt loads and college costs. Today, a look at some potential reforms.

Means test against future income. A college degree is an investment in a future lifetime cash flow that is presumably higher than the potential income from a high school diploma alone. Like any other investment, borrowers and lenders should consider the potential return on investment or ROI from such a substantial obligation.

Several studies have ranked ROI by college major using readily available public information. A comprehensive 2021 study by the Foundation for Research in Equal Opportunity looked at 30,00 bachelor’s degree programs and estimated a median lifetime income premium of $306,000 above an average high school diplomate assuming a 100% probability of graduation. Adjusted for average dropout rates, that number falls to $129,000. However, 25% of bachelor’s degrees actually had a negative ROI, meaning that students in these programs don’t earned back the cost of college during their entire lifetimes. STEM degrees including computer science and engineering carried the highest lifetime ROI, while fine arts, music, psychology, and religious studies had the lowest (frequently negative) average return. 

The disparity is even more striking in graduate education, which represents nearly half of all student loan debt. Roughly 40% of all master’s degrees yield a negative ROI.

This is certainly not to minimize the value of a degree in the arts or liberal studies, but as a purely financial matter, in the absence of scholarships, student should consider the cost carefully in their choice of schools. 

The current system is agnostic as to future earning potential, unlike virtually any other source of credit. A student’s future ability to repay should factor heavily into the lending equation.

Require evidence of financial literacy. The outcry from so many adults who contend they did not understand the terms of their loans points to a deficiency in American understanding of personal finance. Before signing a 5-figure obligation, rising college students should be required to pass a basic financial literacy test or be required to complete a remediation course offered by their institution. Many universities administer entrance exams to gauge proficiency in math or language and require remedial coursework to address deficiencies. Demonstrating a basic grasp of a one’s loan obligation should also be considered a minimum requirement. “I was confused” doesn’t cut it when the Visa bill arrives. 

Skin in the game for colleges. Given the substantial default rate of student loans, the current program represents a significant transfer of wealth from taxpayers to universities. Recent for-profit college scandals notwithstanding, most institutions have not been held sufficiently accountable for the outcomes of the loan programs into which they direct or counsel incoming students. Schools should be required to share some of the burden of defaulted loans and advances to enrollees who fail to graduate. Shouldering partial liability for poor outcomes would provide an incentive to financial aid officers to recommend appropriate packages.

Another proposal worth considering is a risk pool into which premiums are paid by the institutions based on a percentage of the loan award. This insurance fund would partially indemnify taxpayers against subsequent loan losses much like the FDIC covers bank depositors or the PBGC insures pension plans.

Phase out private loan servicing companies. When the private loan guarantee program ended in 2010, a political compromise allowed the former lenders to maintain their role servicing and collecting on existing guaranteed loans and all newly issued government direct loans. By any reasonable standard, the result has been a wreck.

Nothing in the student loan complex has been more problematic than the cadre of private sector companies acting as contractors to Uncle Sam in servicing loans. Billions of dollars in profits have accrued to shareholders, executives, and universities at the expense of borrowers and taxpayers over the life of the program. The industry has been scandal-plagued and is rife with complaints of mismanagement, sloppy record keeping, conflicts of interest and outright fraud leading to over $2 billion in judgments and legal settlements. Thousands of borrowers have been effectively denied relief for which they are eligible or directed into predatory refinancing schemes.

In 2021, the Secretary of Education announced substantial reforms to the broken system, prompting two large servicers to exit the game. Greater transparency, a new centralized database and borrower portal, and better-defined income-based repayment plans are promising developments. But one thing the government knows how do is collect money (although it remains far more proficient at spending it), and managing loan accounts is not terribly different from administering Social Security benefits. Cut out the middleman.

The list is hardly exhaustive, and reform may seem overwhelming. But inaction is hardly a viable option. Even after President Biden’s one-time relief, the total debt burden is likely to rebound to current levels over a decade. Debt forgiveness only treats the immediate symptom, but without systemic therapy for the underlying disease the patient will relapse at taxpayers’ expense.

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