In the last year few years, many have questioned the value of higher education. While it is still one of the best ways to climb the economic ladder, structural issues are emerging. Topline tuition prices are outpacing inflation. The student debt load is booming. Outcomes such as employment and ability to repay loans are being questioned for certain types of degrees as well as entire educational institutions. Why are students jeopardizing their financial futures with shaky educational investments? Many factors contribute to this complex problem. One particularly mundane, subtle, and nefarious source has skirted the conversation’s attention: government student loan rates.
By and large, students pay the same rates on their government-backed loans1, regardless of school, degree, or major. Some loans are only available for graduate degrees, and students with economic need can obtain subsidies for their undergraduate education, but that is the extent to which rates change. Underneath this egalitarianism lurks a hidden subsidy that harms both the student and the taxpayer.
Understanding how a one-size-fits-all loan rate is contributing to the problem of high debts and low value requires a jaunt through the sleepy world of loan price determination. The Minneapolis Fed handily outlines the three approaches to calculating the interest rate of any loan: cost-plus, price-leadership, and risk-based2. Of these three methods, risk-based is preferred as it most directly incorporates the risk that the lender is taking. Risks broadly fall into two buckets: nonpayment risk and technical factors. Nonpayment risk is the likelihood that the loan goes into default — it cannot be paid back and at some point must be written off as a loss. The technical factors include risks such as interest rate risk, prepayment risk, loan duration risk, and the like. While these technical factors do contribute to the rate the borrower pays, they can be considered as a constant, universal risk that does not drive the price a specific borrower will pay. As the two buckets of risk increase, the rate a borrower must pay increases.
Default risk can be further broken down into three categories. All of these risks have the same impact: they make it more likely that the borrower will not pay back his or her loan. Uncontrollable life events such as fatal diseases and catastrophic car wrecks can have a detrimental impact on loan repayment and are considered idiosyncratic risks. The second pool of risks are attributed to the institutional quality of the education that the loan is funding: is the content topical, does academic advising help students find the right fit and path, and does the school help with career placement. The final risk is based on the individual borrower: his credit score and other factors that may indicate that he is less likely to pay back a loan.
Take the unsubsidized Stafford loan rate available through the Department of Education as an example. If the 6.8% rate that the borrower pays reflects the risks underlying the loan, then everyone is equal and all is well in the world! This flat rate implies that everyone has the same risk — the technical, the idiosyncratic, the personal, and… wait…the institutional? “Corporations are people” jokes aside, is the government intending to help students pursue education, or institutions pursue customers? By setting all prices — and thus risks — equal, the government is inadvertently making high-risk institutions cheaper and low risk institutions pricier. Perversely, the loans funding education at institutions that do a poor job preparing students to attain the jobs that would allow them to repay their loans are being discounted. This subsidy impacts the three major players in the education market: the students, the government, and the schools.
Students already face a complex decision when choosing where to earn their degrees. Educational outcomes, such as getting a good job and loan repayment, are the most opaque and difficult areas to assess. Since interest rates are equalized, they cannot serve as an effective signal of the riskiness of the school. In this low-information environment, students of all stripes are harmed. Students at schools that will surely yield good employment, whether majoring in Economics at Harvard or Nursing at a community college, pay too much. Students at low quality schools are endangering their long-term financial health; if they had more information, these students may even prefer to go to a different school. Those students that are able to successfully emerge from low quality schools with a job in tow win in this system, as they benefit from the subsidy without realizing the risk of a poor outcome.
The government — we, the taxpayers — uniformly loses. In the short run, citizens are emerging with worse educations and fewer jobs than they would in a properly priced market. This outcome reduces the nation’s human capital, as well as tax receipts. In the long run, the risk-price gap bites back in two ways: the long overdue and default loans must be written off at a loss, and more importantly, a nontrivial segment of prime working- and consuming-age citizens are condemned to an indebted underclass due to their unpaid loans. Thanks to deft lobbying over the last twenty years, student loans are non-dischargeable in bankruptcy in all cases except for death or dismemberment.
If students are stuck with the bill and the government is left holding the bagguarantee, then who wins? Quality institutions that adequately prepare students for society don’t; they are overpriced. The effective price a student pays is a function of net tuition (list price minus scholarships and discounts), the loan rate, and how long the loan is outstanding; higher loan rates, all else equal, lead to higher effective prices. Academics have begun digging into the economics of poor-quality educations. In a recent working paper3, Professors Demind, Goldin, and Katz of Harvard University dig into a set of rich longitudinal data and find that the for-profit colleges and universities fit the bill. Unemployment and debt burden is higher while earnings are lower years after entering a program. Default rates, even when taking into account demographic, financial aid, degree, year, and city effects, are higher for graduates of for-profit institutions. Naturally, such a subsidy is boosting growth —Professor Douglass of UC Berkeley paints a picture of an industry4 in hypergrowth: from 2000 to 2010, enrollment in for-profit institutions has grown by 235%. Is this outcome the intention of a seemingly egalitarian Federal student loan program?
The fix is straightforward: expand upon data-gathering programs like the Gainful Employment Information Rates5 and use that data to vary student loan interest rates based on institutional risk. Require all schools to track outcomes by degree and program. The idea that students, regardless of background, should have an equal shot at education should continue — personal risk factors should not factor in. Incorporating risk into the price does two things: the effective price of high-outcome institutions will drop, enticing more students to apply and join, and the information on outcomes will be much more salient in students’ decisionmaking. Students get better education, society gets lower costs and a more productive populace, and institutions that are effectively innovating and educating see a bump in popularity.
Is this fair? There is an alluring simplicity to the idea that everyone can get the same rate on an educational loan. Probing this premise yields interesting questions: should society push students towards sub-par educations, and is it fair for taxpayers to subsidize an industry that hurts them? Ultimately, an education program should treat people equally. The educational institutions should be held accountable for the risk they deserve.
1 http://studentaid.ed.gov/types/loans/interest-rates 2 http://www.minneapolisfed.org/publications_papers/pub_display.cfm?id=3030 3 The For-Profit Postsecondary School Sector: Nimble Critters or Agile Predators? http://scholar.harvard.edu/goldin/cgoldin/publications/profit-postsecondary-school-sector-nimble-critters-or-agile-predators 4 Money, Politics And The Rise Of For-Profit Higher Education In The Us: A Story of Supply, Demand and the Brazilian Effect http://cshe.berkeley.edu/publications/publications.php?id=396 5 http://studentaid.ed.gov/about/data-center/school/ge