Guest Post: Creating Seamless, Student-Centered Loans

By Art Hauptman

The sub-prime lending crisis has brought student loans back into the policy limelight as government officials and advocates of different stripes have sought to ensure adequate loan availability for the coming academic year. But resolving the current set of concerns should not obscure the continuing need for broader reforms to ensure the long-term availability of student loans at a reasonable cost to both borrowers and taxpayers.

As recent events perfectly illustrate, policymaking on student loans has often been driven by real or perceived crises regarding banks’ continued willingness to lend. Lawmakers and Congressional staff spend countless hours trying to determine what the exact right subsidy for lenders should be, rather than ensuring that the programs are continuing to fulfill their broader federal goals of promoting students’ access and success in college. Instead of taking a patchwork approach, fundamental reform is needed.

Here are some key challenges the loan programs face:

• The programs are highly fragmented with private lenders of federally-guaranteed loans competing with Direct Loans in which federal funds are used to finance borrowing. As a result, similarly-situated students can end up with different terms on their federal loans depending on their colleges’ choice of loan programs. In addition, students often are confused by the range of borrowing options — which can complicate their lives greatly once they enter repayment.

• Student debt burdens have mounted over time to the point that millions of students are having trouble repaying their loans. With college prices continuing to grow rapidly, students are getting even deeper in debt by taking on private loans with more costly terms and fewer protections.

• Subsidies in the federal loan programs are not well targeted on students who need them the most. The federal payment of interest while borrowers remain in-school — by far the largest cost item — is available to students with family incomes well in excess of $100,000 if they go to higher-priced institutions.

• Although the Guaranteed Student Loan program was intended to be market-like, many of its features are not. Congress, for example, determines how much lenders receive to compensate them for the difference between government-set student interest rates and market-rates of interest. The size of these payments and the way in which they are set has led to an ongoing set of shrill debates and a very complicated reimbursement scheme that lasts the life of each loan.

• Although this is controversial, I continue to believe that the large expansion in federal loan availability for students and parents over the past quarter century is a factor in the rapid run-up of tuition at both public and private colleges.

One of the great difficulties in trying to restructure student loans is what to do about $400 billion in outstanding loan paper. Unlike changes in Pell Grants that affect only students in the future, efforts to reform student loans must recognize the rights and responsibilities of both the borrowers and holders of these existing loans.

We must begin to shift the policy focus away from when the loans are made to when borrowers actually enter repayment. A first step in this direction would be to have the government finance loan repayment centers on campuses, in communities, and on the Internet that can counsel student loan borrowers about how best to manage their loan obligations as they prepare to enter repayment.

A seamless student-centered approach also requires a number of specific reforms, including the following:

• To reduce complexity, the terms of new loans should be the same for all federal student loan borrowers.

• Federal payments of in-school interest should be limited to Pell Grant recipients rather than the current practice of subsidizing borrowers on the more broadly-based criteria of financial need, which brings in many higher income borrowers.

• All student loan borrowers should be allowed to consolidate their debt when they enter repayment at the same terms and conditions as new loans. Borrowers should also explicitly be given the option of repaying their student loans as a percentage of their income. Existing consolidation and income contingency provisions have been underutilized because current loan holders often can veto these arrangements.

• The government should annually auction a portion of existing loans to determine the underlying market rate on student loans. The results of the auction would then determine a single federal payment to lenders each year to compensate them for the difference between student rates and market rates of interest.

In addition, it is also critical that institutions are encouraged to minimize borrowing by their students in at least two ways. First, they should be required to pay a portion of each loan that is defaulted by one of their students. This will reduce their willingness to send so many students to the nearest loan window.

Second, and perhaps more important, we need to change the expectation that colleges can continue to raise their prices and that more loans, either federal or private, will follow. To do this, we should limit the amount students can borrow to a percentage of tuition, say 50 percent, and a standard amount of living expense. Colleges would then be required to provide discounts to students borrowing the maximum loan amount.

Many will argue that this will reduce access to higher education. But that assumes the sticker price is what students must pay and that when institutions raise their prices, students have no choice but to take on bigger loans to pay the bill. This proposal is designed to help sever or moderate whatever connection may exist between loans and rising charges because institutions would effectively have to offer discounts to their borrowers to make up for missing resources that would be the result of higher prices.

Streamlining federal student loans in this manner will not be easy as the proposals step on the toes of lenders and institutions alike. But doing so is an absolutely key component to any broader effort to improve how postsecondary education is financed in this country.

Art Hauptman is an independent consultant on higher education finance issues. Views expressed herein are his own and do not necessarily reflect the positions of the New America Foundation.