Loan programs

Subprime Student Loans

An unintended consequence of making access to college an entitlement readily available to all high school graduates is that serious study in high school has become optional, even for those intending to go to college. Without an incentive to study diligently, many students are disengaged in high school and, as a result, underprepared for college. Some freshmen arrive at college thinking that having fun is the main reason they are at college and that the pursuit of knowledge should be available for when they have nothing better to do.

This situation came about relatively recently, partly the result of a change in the meaning of financial aid. Until World War II, financial aid referred to traditional scholarships that were awarded to academically meritorious students who mostly also were needy. The G.I. Bill, which financed college for discharged veterans of World War II, foreshadowed broader programs of federal grants and loans -- 20 at present from the federal government, 17 from the Department of Education and 3 more from other federal agencies -- that essentially universalized "financial aid." Few of them require better than mediocre previous or current academic achievement. As a consequence, about 30 percent of incoming freshmen at four-year colleges and over half the freshmen at two-year colleges are assigned to remedial courses in writing, mathematics, or other courses.

Nevertheless, federal grant programs, though supplemented by state and private grant programs, were never able to cover the financial needs of the millions of college students whose families could not afford the rising costs of attending college. So Congress established several loan programs, some indirect loans whose federal subsidies made attractive to banks, credit unions, and other financial institutions, and some financed directly by the Department of Education. Unlike Pell Grants and other federal grant programs for college students such as work-study programs for needy college students, which do not have to be repaid, loans must be repaid with interest after graduating from or leaving college.

Repayment is a problem for student borrowers. Many of these loans are subprime -- toxic in the same sense that some mortgages were toxic. They are even more likely to be subprime than mortgages are; the only collateral is usually the student’s future earning prospects after graduating, presumably enhanced by what he or she has learned at college. Student borrowers who do not learn enough from their educations to get jobs that permit then to repay what they have borrowed are likely to default on their loans, leaving taxpayers liable for them.

The student financial aid system was created by Congress not as an integrated system but in pieces: to do a variety of things for a variety of reasons. One major objective was to help youngsters from low-income families gain access to higher education. In the light of our egalitarian ideals, limiting educational preparation for good careers to children fortunate enough to have educated, affluent parents seemed immoral. A second reason for promoting college access for youngsters from low-income families is that, as Jefferson argued, persons of extraordinary talent may be born in humble circumstances, and giving them educational opportunities might enable the American economy to be more productive. The knowledge explosion during the 20th century demonstrated that ideas are extremely important to the "creative destruction" that a market system needs in order for the economy to grow. Institutions of higher education are where many new ideas are developed by adults through research and transmitted to youngsters through teaching. Politicians are referring to this economic growth function when they speak euphorically about student grants and loans as "investments." Realistically speaking, however, only a few federal grant programs -- and none of the loan programs -- seek out top-notch students who will presumably contribute most to the productivity of the American economy; others aim only to make accessible the college experience for children of lower-income families. The existing system is an uneasy compromise between these two objectives.

It is an uneasy compromise partly because promoting access for youngsters from low-income families sometimes conflicts with the meritocratic ideal of educating youngsters most capable of making great intellectual contributions to knowledge. A better compromise could be made to realize these two objectives by targeting the grants and loans devised by the federal financial aid program to needy students studying diligently in order to prepare to go to college. Instead they were set up mainly as incentives simply to go to college, prepared or not. Congress apparently assumed that the colleges would screen admissions appropriately or perhaps Congress was afraid to appear elitist by imposing meritocratic conditions. Thus, federal aid to college students removed most financial barriers to attending college. Applications increased as high school students heard the message that college attendance led to well-paid, interesting careers, and was now affordable. Many colleges expanded facilities and lowered academic standards for admission; virtually any high school graduate could get into some college. Students might have had an incentive to work harder in high school if they had had to demonstrate academic achievement both to gain admission to college and to obtain financial aid to cover expenses while enrolled. The unintended consequence of failing to set this requirement is students graduating from college without good job prospects, a problem made worse in an economy where the unemployment rate has now risen above 10 percent. The predictable result is a growing rate of student loan defaults.

I am about to propose to change federal loan programs to college students but not to change federal educational grants to college students. Why the difference? Both suffer from the same drawback; they entitle mediocre as well as able students to obtain federal financial aid. A different approach is justifiable because federal loans have much worse consequences for both students and taxpayers than federal grants.

Consider grants first. As gifts from American taxpayers that students do not have to repay, it is true that grants are a complete loss to taxpayers if students do not make contributions to American society as a result of going to college. On the other hand, grants involve less than half as much money as loans in the aggregate as loans. And even individual cases of defaulted loans, accompanied as they are by interest and penalties, can be very large burdens both to American taxpayers and to individual student borrowers. In a November 2009 case decided by a panel of five New York State judges who ruled against admitting a student borrower to the New York bar, the panel said, “His application demonstrates a course of action amounting to neglect of financial responsibilities with respect to the student loans he has accumulated since 1983.” The student owed nearly half a million dollars. This admittedly unusual case shows the advantage to both students and taxpayers of grants over loans. Because there are strict limits to the annual grants that students can receive from the Department of Education in any academic year, students cannot attend college whose costs are way beyond their means.

With the help of Pell and other grants, students can afford a community college even if they cannot get loans rather than an expensive private college, especially if they live at home and commute. Students who start at community colleges and are successful academically can transfer to four-year colleges for their junior and senior years. In other words, student grants ignore academic merit even though everyone knows that students who have not done well in high school are unlikely to do better in college. These grants are an expression of American society’s willingness to make higher education available even to students who are poor risks. Giving Pell Grants is a societal bet -- though a long shot -- that mediocre students are late bloomers and can do better scholastically in the future, not that mediocrity is acceptable in itself.

This bet is riskier for loans, and consequently I recommend that loans be treated differently. Congress and the President should start to require the Department of Education to make student loans contingent on the best available evidence of the student’s prospects for repaying them, such as good job prospects based on high school and college grades, curriculum in which they enrolled, and their credit ratings. Defaults would still occur. Predicting the earning potential of college students is chancy. However, many young people would almost certainly be saved from financial ruin, and American taxpayers would almost certainly not have to bail out as many subprime student loans.

As theologians have said, we mean well and do ill and justify our ill-doing by our well-meaning. The unintended consequences of good intentions apply to our system of financial aid to American college students, as it did to our providing mortgage money to borrowers who could by no stretch of the imagination have kept up payments on their mortgages.

To sum up: Federal grants give mediocre students a chance to become late bloomers. Loans, however, are expected to be repaid, and mediocre high school students with bad credit ratings are likely to default on their loans, causing serious financial problems for themselves and financial complications for the American economy. Targeting loans to students with good prospects for repaying them is more prudent financially and makes more sense educationally. Some illiterate high school graduates have already sued their high schools for educational malpractice; disappointed college graduates may follow suit. Some diplomas are "tickets to nowhere."

Author/s: 
Jackson Toby
Author's email: 
info@insidehighered.com

Jackson Toby is professor emeritus of sociology at Rutgers University. His new book, The Lowering of Higher Education in America: Why Financial Aid Should Be Based on Student Performance,was published last month by Praeger.

A Better Way to Borrow

By now, most prospective college freshmen have already found out which colleges they’ve been admitted to, and the grueling process of refreshing e-mail accounts and camping out by the mailbox has ended. But for many of these students, the worst anxiety begins now, as the reality of paying for college sets in. The U.S. college loan system has recently undergone important changes, with the goal of easing the burden on graduates, but serious problems remain. Those facing high debts may still find themselves struggling to make payments, and confused about their options.

It is of great interest to note that this predicament was addressed and solved in Australia in 1989 – through income-contingent repayment systems that go beyond anything in the United States. The system has been effectively copied in many other countries. The U.S, system remains fraught with problems even though the solution has been transparent for over 20 years.

To finance the staggering costs of education, students in the United States have increasingly relied on both federal and private loans. The debt burden facing recent graduates during what are often their least financially fruitful years has serious consequences. For those students who make it to graduation, the reality of impending repayment obligations may cause them to choose higher paying jobs instead of lower paying jobs with high social value, such as teaching and social work. Students who find themselves overwhelmed by their debt burden or unable to make payments may default on their loans, harming their credit and fueling the need for government-funded collection costs.

Recently, policies have been enacted in the hopes of alleviating some of the debt burden facing graduates. A 2007 law created a new repayment method for federal loans, Income Based Repayment (IBR), which in theory allows graduates facing economic hardship to tie their loan repayments to their future income and allows borrowers to defer payment during years in which their incomes fall below a certain threshold. IBR caps graduates’ repayment obligations at 15 percent of their discretionary income, in theory, and forgives remaining debt after 25 years of consistent repayment. The Reconciliation Act of 2010 made IBR more generous for students taking out federal loans after 2014.

These developments are encouraging, but this new approach does not go far enough to relieve the incapacitating debt burden experienced by many graduates. The convoluted nature of the federal lending system and the limitations of these reforms call into question the extent to which people will make good use of IBR. As such, it is very likely that the expected improvements in college access and loan default reduction will not be fully realized.

The process of qualifying for IBR requires substantial administrative effort to prove economic hardship. Navigating this process and understanding the multiple repayment options that exist is very complicated, and will prove unworkable for some borrowers. IBR cannot offer the greatest comfort to graduates concerned about sudden changes in post-graduation income, as the period of time in which a borrower can apply for IBR is only 45 days at the beginning of each year. Consider what has to be done by graduate debtors with respect to IBR when events in their lives change. IBR allows for lower payments than a standard repayment plan when the borrower’s income is above a certain level. Eligibility is determined by calculations that consider both a measure of the borrower’s tax liability, called “Adjusted Gross Income” (AGI), and 150 percent of the poverty line. Both AGI and poverty line calculations can be affected by many different factors, meaning that IBR eligibility calculations can also vary considerably over time.

For example, the AGI changes if a debtor experiences an income change (for example, through promotion, salary cut, or job loss). The poverty line calculation is affected if a debtor gets married or separated, has a spouse whose income changes, or experiences a change in the size of his or her household (eg, from having a child). When each of these (commonplace) changes occurs, graduates must provide their lender(s) with convincing income documentation (payslip, letter from employer, bank statement, etc). Each year, lenders will assess income and family size to adjust the IBR repayment accordingly. A typical person moving, changing jobs, getting married or having children will have to do this each time, and separately for each of their lenders.

Perhaps even more problematic is the fact that although debt remaining after 25 years of loan repayment is meant to be forgiven, the amount of this remaining debt is still treated as taxable income, undermining the goal of assisting those borrowers who face the most difficult economic situations. Additionally, while IBR is a more reasonable repayment method in concept, its implementation may do little to address the expensive inefficiencies associated with the complicated federal lending system. The creation of a more efficient lending system devoid of unnecessary complications and expensive collection agencies could create even more cost savings and free up more funds to help those students with the greatest financial need realize their professional goals.

The data on the incomes of American college graduates suggest strongly that a significant proportion of students with debt will be in a position that requires IBR action. For example, we have calculated that 40-70 percent of those who attend college can expect to have the relevant income and poverty level sometime in the 10 years following graduation. If, as expected, college graduates find the income-based repayment process confusing and daunting, they may remain in a standard repayment plan in which those with relatively poor financial circumstances will find themselves allocating substantial proportions of their incomes to loan repayment. We have calculated, for example, that those ending up in the bottom quarter of young graduate income earners with average student debt of $20,000 would need to devote around 30 percent of their incomes to service the debt. A significant proportion of college dropouts with debts of just $10,000 will have to allocate over 25 percent of their incomes towards this end. For many, this will lead to significant burdens and even default.

This important U.S. problem seems very odd to outsiders. In Australia, for example, student loans do not cause these sorts of collection problems because they are repaid not on the basis of regular set amounts, but instead depend directly and automatically on a graduate’s income as recorded by income tax authorities. This is an example of an automatic income contingent loan, a concept which was thought up, independently, by two Nobel winners in economics, Milton Friedman and James Tobin.

Australia led the world by introducing automatic student loan repayment in 1989, paid through the income tax system. The policy was designed to achieve all the protections inherent in the current U.S, moves toward income-based repayment, and to do so without the complicated administrative arrangements or detailed planning that characterize IBR. Student borrowers don’t have to clear any hurdles when they experience low incomes.

The Australian system is known as the Higher Education Contribution Scheme (HECS) and it works as follows: when students enroll in college they may elect to pay their tuition later in a way that depends on their future incomes. Eighty-five percent of students take up this option. The debt is recorded with the Australian Internal Revenue Service and is taken from a graduate’s income, at a maximum of 8 percent of incomes, but only when incomes exceed about U.S. $35,000 a year. If the former student is in poor circumstances, for example from being unemployed or in a low-paying job, no payments are required, and no action is needed by the debtor to prove these circumstances. There are no poverty line recalculations, no need to adjust repayments with marriage or separation or the birth of a child; it is all automatic and simple. When Australian college debtors’ incomes recover, their repayment amounts increase, yet never to more than 8 percent of incomes.

The very simple facts about the Australian versus the U.S. loan systems are that in Australia there is no default because of low income, people with debts face no repayment hardships and graduates do not have to take high income jobs in order to be able to afford repaying their loans. And all this happens with no action needed by Australian graduates, and with no required expertise or information needed on how to master complex and demanding administrative arrangements.

The success of HECS has encouraged a quiet international revolution in college loans, away from the U.S.-style and toward the Australian. New Zealand adopted a similar plan in 1991, South Africa in 1991, the UK (partially at first in 1997 and now in full swing), Hungary in 2003, and similar efforts are planned for Malaysia, Ireland and other countries in the near future. All the evidence is that these systems have worked well and the government gets back the vast majority (85 percent) of the debt without defaults or repayment hardships from low incomes.

It seems that U.S. college students are being left behind in terms of international reforms of loan arrangements. Automatic loan collection offers distinct advantages over current U.S. approaches, and given the demonstrated success and fairness of these systems in other countries, the time seems right to debate the issue in earnest in the United States.

Author/s: 
Bruce Chapman and Yael Shavit
Author's email: 
info@insidehighered.com

Bruce Chapman is professor of economics at Australian National University. Yael Shavit will be starting Yale Law School in September.

A Federal Impediment to Quicker Degrees

In February 2009, at a meeting of the American Council on Education, I challenged a group of university presidents and other leaders of higher education to focus on the need for greater innovation in higher education. I encouraged those leaders to heed the lesson offered by George Romney to the auto industry in the 1970s to innovate or lose their advantage: “There is nothing more vulnerable than entrenched success,” he said. I followed up in October 2009 with an article in Newsweek entitled "The Three-Year Solution: How the reinvention of higher education benefits parents, students, and schools."

The response has been pleasantly surprising.

Over the past year and a half, a growing number of institutions of higher education came forward with proposals to offer three-year degrees to their students. Here are a few examples:

  • Grace College, in Winona Lake, Ind., is offering an accelerated three-year degree in each of its 50-plus major areas of study. Dr. Ronald Manahan, Grace's president, cites the cost of college as a driving force behind the decision. “We have listened to people’s concerns about [the cost of] higher education and we are answering them,” he said.
  • Chatham University, in Pittsburgh, Pa., is offering a three-year bachelor of interior architecture without summer classes, allowing students to get into the job market a year earlier. School officials have reconfigured the four-year degree by cutting Studio classes from 14 weeks to just seven, and when compared to similar programs, these students graduate two years earlier.
  • Texas Tech University, in Lubbock, Tex., is offering an accelerated three-year medical degree, rather than the usual four. The program is aimed at making it easier and more affordable for students to become family doctors.

As institutions of higher education look into the possibility of offering a three-year degree, some have run into federal policies that seem to interfere with their ability to innovate. For example, this May I received a letter from Jimmy Cheek, chancellor of the University of Tennessee-Knoxville, describing a potential obstacle to a three-year degree surrounding student loans.

Here’s the issue: Under the Higher Education Act, student loan limits are tightly set to prevent over-borrowing by students. Federal annual loan limits and lifetime loan limits establish a maximum amount one can borrow under the federal student loan program. The annual loan limits are designed to pay for two semesters per year (see chart below).

Example: Scheduled Academic Year

Academic Year Semesters

 

Loan Amount

 

 

Scheduled Academic Year 1

 

 

Fall 2010 and Spring 2011

 

 

$5,500

 

 

Scheduled Academic Year 2

 

 

Fall 2011 and Spring 2012

 

 

$6,600

 

 

Scheduled Academic Year 3

 

 

Fall 2012 and Spring 2013

 

 

$7,500

 

 

Scheduled Academic Year 4

 

 

Fall 2013 and Spring 2014

 

 

$7,500

 

 

 

 

 

Total

 

 

$27,000

 

 

For most institutions of higher education, and most students, this works and makes sense. But 3-year degree students often take a third semester’s worth of classes over the summer. The federal limits appear to prevent students from obtaining a loan to pay for those summer courses.

Fortunately, there is a solution. Working with the Congressional Research Service, and the staff of the U.S. Department of Education, my office has identified an option that exists under current regulations to give flexibility on these loan limits to institutions of higher education and students. Instead of following a standard “Scheduled Academic Year” as outlined above, an institution of higher education offering a three-year degree could award loans to students through a “Borrower-Based Academic Year," per the chart below:

Example: Borrower-Based Academic Year

Academic Year

 

Semesters

 

 

Loan Amount

 

 

Scheduled Academic Year 1

 

 

Fall 2010 and Spring 2011

 

 

$5,500

 

 

Scheduled Academic Year 2

 

 

Summer 2011 and Fall 2011

 

 

$6,600

 

 

Scheduled Academic Year 3

 

 

Spring 2012 and Summer 2012

 

 

$7,500

 

 

Scheduled Academic Year 4

 

 

Fall 2012 and Spring 2013

 

 

$7,500

 

 

 

 

 

Total

 

 

$27,000

 

 

This option would use the same annual loan limits and lifetime loan limits, but compress them to match the student’s academic schedule. Compared to the typical “Fall-Spring” academic year over each of the four years, a three-year degree program could use a “Fall-Spring, Summer-Fall, Spring-Summer” structure to allow for a compressed academic schedule.

I have been told that this “Borrower-Based Academic Year” option is currently not well used because it is administratively complicated for institutions to offer both “Scheduled Academic Year” and “Borrower-Based Academic Year” loan structures at the same time for individual students. But for an institution that offers a comprehensive three-year degree program involving a number of students, this seems to make sense as a way of helping students in that program afford the tuition and fees.

I have asked Chancellor Cheek to let me know if this option would work for the University of Tennessee, or if more flexibility needs to be added. When Congress last reauthorized the Higher Education Act in 2008, we made several changes to the Pell Grant program to allow that funding to be used on a year-round basis. There is no reason students should not have that same flexibility with their student loans.

It is my hope that more institutions will explore innovative ways to provide a high-quality postsecondary education. The three-year degree is one idea for some well-prepared students, but it is vital to our competitiveness as a nation that we develop other ideas to improve the efficiency of higher education and expand access to more Americans.

Institutions of higher education are rightly feeling pressure from parents, students, state and local leaders, the business community, Congress, and the Obama administration to do a better job of providing more Americans with a quality college education at an affordable price. That pressure will likely grow more intense every year as more jobs require higher education, advanced certificates, or technological skills from their applicants.

Some have asked whether all colleges and universities should be required to offer a three-year degree. My answer is a resounding no. Just as the hybrid car isn’t for everyone, all students and all institutions won’t want a three-year degree. The last thing we need is more federal mandates on higher education.

The strength of our higher education system is that we have 6,000 independent, autonomous institutions that compete in the marketplace for students. It is that marketplace that needs to develop the new ideas for the future -- and not become a victim of its own “entrenched success" -- so that our students, and our country, can continue to thrive.

Author/s: 
Senator Lamar Alexander
Author's email: 
doug.lederman@insidehighered.com

Sen. Lamar Alexander (R-Tenn.) is chairman of the Senate Republican Conference and a member of the Senate Committee on Health, Education, Labor and Pensions. He served as U.S. secretary of education under President George H.W. Bush and as president of the University of Tennessee.

Variable Rate for Loan Consolidation 'Viable,' GAO Says

Smart Title: 

The Education Department's proposal to start charging a variable interest rate instead of a fixed, low rate to borrowers who combine multiple federal student loans into one is a "viable option for reducing federal costs" in student loan programs, the U.S. Government Accountability Office said in a February letter to Republican lawmakers, who had requested the review.

Loan Battles in Banks and Congress

Smart Title: 

Direct lending supporters accuse some lenders of delays on consolidation; Democrats and Republicans trade charges in Congress.

Borrowing More, Earning More

Smart Title: 

Changes in federal policy in the 1990s led students to take on more debt, but higher post-graduation salaries helped them start repaying the funds.

Growing Market for Loans

Smart Title: 

Sallie Mae unveils new programs for community colleges -- at a time when borrowing by some of their students is on the rise.

Court to Rule on Delinquent Debt

Smart Title: 

Can the U.S. go after a student loan defaulter's Social Security benefits? The justices will decide.

Bush vs. Bankers

Smart Title: 

There is no such thing as an offhanded comment from a White House spokesman.

So when Trent Duffy, in explaining Friday that President Bush would seek to bolster the Pell Grant program in part by reducing the subsidies paid to lenders in the student-loan program, called the subsidies "excessive" and described the loan industry as "very profitable," the political winds surrounding the student-loan programs continued to shift.

New Analyses on Aid Policy

Smart Title: 

Studies are released on students who borrow and then drop out, and on the role of private scholarships.

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