Tuesday, May 25, 2010

Kill Them All (with Debt) and Let the Market Sort 'Em Out

Daniel Bennett wrote an article for Forbes on the rising default rate for student loans. Apparently, the 90-day default rate for private loans is up to 6% and the 30-day default rate is up to 7.5%, an increase from 5.4% and 6.8%, respectively. The default rate on federal student loans went from 6.7% in 2007 to 7.2% in 2008.

Bennett notes that if private student loans are rendered dischargeable in bankruptcy, as they were prior to 2005, this would increase the risk to lenders, leading to higher interest rates for those seeking professional degrees, which are almost certainly financed in part through private loans. It would also discourage low- to moderate-income borrowers from pursuing these degrees due to high loan costs. He does not provide any data supporting these assumptions. One would think it would not be difficult to provide such data, considering private loans have only been protected for a little less than 5 years.

Bennett's solution is for the government to get out of the student loan business and let the market sort it out. Private lenders could assess a borrower's risk of defaulting on the loan and set the interest rate accordingly. There are a few problems with this solution. First, most first-year college students would not qualify for an unsecured private loan without a co-signer with good credit. Which leaves a huge chunk of college-bound hopefuls with their cheese out in the wind. (I, myself, could never have qualified for a private loan during my undergraduate career, nor did I have parents or relatives who could co-sign for me.)

Second, even if private lenders are prohibited from turning down a borrower due to poor credit or no credit (which is the policy of federally-backed loans), then increasing the interest rate seems like it would adversely affect only those students who do not come from well-off or even middle-class families who can co-sign for these loans to get lower interest rates.

Finally, setting the interest rate at the time a student applies for the loan does not make much sense since the student's credit-worthiness will most likely go up after he or she earns the degree (J.D.'s excluded, of course). So, you could have a student with no credit, no co-signer and no income, sign up for a loan at 10% and then graduate with a nursing degree with $50K in student loans. If the student secures gainful employment upon graduating, it seems like the interest rate should reflect the student's likelihood of repaying the loan at that point (when he or she is entering a field with high demand and good income potential), not four years prior, when the student had no money, no credit, and no prospects.

Bennett also proposes that colleges share in the risk of student loan defaults. This would create an incentive for colleges to actually provide valuable educations, as they promise. I agree with Bennett on this one. Too many institutions of higher education are focused on enrolling as many students as possible and forgetting that about 90% of all undergraduate programs are basically worthless (take it from a PoliSci major).

Do you think student loans should be dischargeable in bankruptcy? Should colleges be held accountable when students default on loans?

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