Student loans are a financial instrument that can be used to borrow money for educational expenses, typically at a postsecondary level, such as tuition and fees, books, and living expenses. Education loans are a means to finance human capital investments and can aid students’ attempts to acquire knowledge and skills by providing money to pay for college. Benefits of college can include not only private rewards, such as higher earnings and better health, but also social benefits, such as reduced crime and more civic participation. This entry will cover how typical student loans work and the decisions to borrow, lend, and repay, and it will conclude with an overview of the education credit market.
Borrowers initially receive funds from lenders, and in return, they are required to remit a stream of future payments. Loans typically come with a cost, as borrowers pay interest (a charge by the creditor for the use of funds) on the borrowed money. The amount that students are able to borrow and the interest rate charged can depend on the cost of attendance, the level of other financial resources available to the student, and the lender, among other factors. Most student loans are installment loans, where debt obligations are repaid in a fixed number of regular monthly payments over a 10- to 25-year time period. Examples of alternative repayment plans are income-based or income-contingent repayment, where remittance amounts vary with debtors’ incomes.
In the absence of personal or other financial resources to completely cover costs, many students and their families need to borrow in order to attend college. In the United States, estimates indicate that more than half of the students borrow education loans annually. The total and per-student amount of student loan borrowing increased in the United States in the 2000s, and loans also comprise an increasing portion of students’ college financing strategies.
The decision of whether and how much to borrow is connected to the decision of whether to attend college. An individual would be expected to enter college if her present value of expected benefits, such as an earnings premium associated with attending college, exceeds the present value of the costs, including tuition, fees, and foregone earnings. In other words, a prospective student should compare the positives she anticipates to gain by attending college against the negatives and attend if the former outweighs the latter. Higher earnings are a significant expected benefit to college, as research consistently demonstrates that graduating from college is associated with relatively positive job market outcomes. For example, the U.S. Bureau of Labor Statistics estimates that in 2012, bachelor's degree holders had nearly half the unemployment rate and more than 1½ times the weekly earnings of those that completed no further education beyond high school.
Students’ calculations of costs and benefits of entering college are far from straightforward, however. Students must calculate benefits among a number of uncertainties, such as macroeconomic conditions, and with heterogeneous returns to education across college types, college majors, careers, and student abilities. For example, students may have difficulty estimating their probability of program completion or the expected earnings differences across fields. Moreover, costs such as foregone earnings may be difficult to precisely predict, and when deciding to borrow, students must be able to understand relatively complicated financial concepts related to student loans.
In periods with high unemployment or with low college wage premiums, a number of concerns can arise related to student borrowing beyond just the costs of default. High levels of student debt can burden students and be an economic drag. Government estimates indicate that outstanding student loan debt in the United States is approaching $1 trillion in 2013, making it the second largest sector of debt in the country behind housing. Students with a great deal of debt may reduce consumption, have reduced access to the credit market, or delay purchases of wealth-building assets such as houses. High debt burdens, moreover, may influence students’ postcollege career choices. For example, when faced with high debt, students may be more likely to choose higher salary jobs, such as in the finance industry, instead of lower paying jobs, such as in the nonprofit or education sectors, that may be more closely associated with serving the “public interest.”
In loan transactions, lenders provide borrowers money in exchange for future repayments of the amount borrowed plus extra charges. A key issue related to student loans is the price (e.g., interest rate and fees) to charge for educational credit. In addition to covering capital, information, and processing costs, the price of credit in other contexts, such as housing finance or payment cards, is often related to the risk of borrower default. Education loans have a number of characteristics that would be expected to lead to high risk-based prices. This, however, may conflict with public goals of encouraging access to education, which is one reason why interest rates in government-sponsored loan programs are frequently maintained at a relatively low level.
Educational loans are typically not secured by physical assets. In the event of default on a loan secured by collateral, the lender will take ownership of the asset placed against the debt, such as a house or automobile; sell it off; and close the loan. Collateral helps lower prices of debt by reducing the costs associated with default. Consider, however, if a student loan borrower defaults on debt obligations. There is typically no collateral for the lender to repossess, since the assets in the transaction are the increased skills of the borrower.
A second distinguishing factor of student lending is that student-borrowers often have thin credit histories. In the absence of collateral to secure the debt, lenders would look to a record of creditworthiness, such as a high credit score, in order to motivate the underwriting of the loan. Many students have not yet had the opportunity to establish a strong credit profile. Borrowers’ probability of default is difficult to estimate without signals of creditworthiness based on prior behavior, leading to increased risk and therefore higher prices. Adding to the challenge, lenders need to forecast students’ ability to repay in the future, after students attend college and therefore have higher, though uncertain and heterogeneous, expected earnings potential. An increasingly common practice because of many students’ sparse credit histories is to require cosigners on student loans. A cosigner will normally have adequate credit history, income, and assets to support the student's borrowing requests and will have to assume repayment responsibility if the student defaults.
Decisions to repay student loans will depend on borrowers’ ability to repay, along with the costs and benefits of default. In the event of an income or asset shock, such as a job loss or drop in house prices, borrowers may not have the ability to service their student loan debt. When faced with financial constraints, moreover, borrowers may use available resources to fund consumption or pay down other debt that preserves liquidity. Reflective of the recent difficult economic conditions, the U.S. Department of Education reports a 2010 default rate on federal program loans of more than 9%, about twice the lowest annual rate of the previous decade. Costs of loan default can be substantial. Default limits future access to, and raises prices in, the credit market because of a damaged credit profile, impairing borrowers’ ability to finance future asset purchases. As well, the government can garnish borrowers’ wages and tax returns if borrowers default on certain loan program obligations.
Because borrowers do not have to relinquish houses, cars, or other physical assets placed against debt obligations, fears that student loan borrowers will engage in strategic default have nevertheless motivated policy decisions. An approach to address concerns about strategic default behavior and lenders’ lack of recovery in the event of a default has been to prevent student loans from being expunged or reduced through bankruptcy. Borrowers in the United States cannot typically purge themselves of either federal or private education debt obligations through bankruptcy, except in cases of undue hardship. This increases the amount of expected recovery by the lender in the event of default, potentially lowering prices. However, critics of the bankruptcy protection argue that it prevents struggling borrowers from financially rebuilding in the event of a hardship.
There are two primary types of student loans in the United States: (1) federal loans and (2) nonfederal loans. Nonfederal loans include those originated by private lenders, as well as loans from state and postsecondary institutions programs. In the United States, federal loans comprise approximately 80% of loan disbursements in the 2000s. Examples of federal loan programs include the Robert T. Stafford Student Loan Program, the Parent Loans for Undergraduates Program, and the Federal Perkins Loan Program. Along with other federal student financial aid programs such as Pell grants, the largest federal education loan programs are authorized by Title IV of the Higher Education Act of 1965 and subsequent amendments.
From the early 1990s until 2010, most federal loan programs were available through two different delivery mechanisms in the United States: (1) the William D. Ford Federal Direct Loan Program (“Direct Loan”) and (2) the Federal Family Education Loan (FFEL) Program. New originations under the FFEL program were discontinued in 2010, leaving the federal government as the remaining provider of most federal loans through the direct loan program. Though terms and borrower eligibility rules under the two programs were equivalent, the source of funds differed. The federal government is the lender and provider of funds under the direct loan program, whereas private lenders, such as banks and some schools, financed loans under the FFEL program. Under FFEL, in addition to public guarantees on the amount owed, private lenders received subsidies from the federal government to maintain a federally mandated interest rate level and to cover expenses associated with loan origination.
Federal loan programs in the United States have many distinguishing features as compared with private lender loans. Most borrowers qualify for federal student loan programs as long as they attend an eligible institution, and rates are typically constant across all types of borrowers, such that interest rates do not vary with expected default risk. Interest rates in federal loan programs are generally subsidized by the government and therefore offered at a lower rate than can be found from private lenders. Some programs have extra benefits for students who demonstrate financial need. In addition, some programs allow students to avoid accruing interest while in school and during grace periods, and students can also often postpone or forbear government loan obligations during times of enrollment or hardship.
Some researchers contend that government subsidies and guarantees lead to an overextension of educational credit. A reason used to justify government involvement in the student loan market, however, is to address the problem of social underinvestment in education. Many believe that public benefits such as reduced crime and more civic participation result in social returns to education that exceed private returns. Consequently, some individuals may not invest in their education at a socially optimal level without a public subsidy. Private employers, moreover, tend to underinvest in generalized training for their employees. An imperfect capital market, where students are unable to borrow uncollateralized loan money against future earnings, contributes to the social underinvestment problem. Human capital investments are not as easy to finance as physical capital investments, since educational credit is generally not secured by collateral and because productivity depends on borrower cooperation. Therefore, a robust student loan market potentially improves efficiency by increasing the supply of highly skilled workers.
Credit constraints are often used to explain gaps in college enrollment between families with high and low incomes. Students from high-income families are more likely to be able to rely on family endowments to defray college costs. Students from low-income families, however, are expected to have fewer private resources to pay for expenses and therefore attend college. Access to student loans, therefore, can play an important role in encouraging college attendance across income levels in an environment where students must finance at least a portion of their schooling. It should be noted that some researchers find evidence of a competing, but not necessarily mutually exclusive, interpretation of college-going differences among income classes. Under this theory, since long-term income factors that influence students’ cognitive and noncognitive development contribute to college attendance decisions, the availability of educational credit may not be sufficient to solve the problem.
See also Federal Perkins Loan Program; Higher Education Finance; Stafford Loans; Student Financial Aid; Tuition and Fees, Higher Education
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