How to fix the real student loan problem

 Last week’s announcement to eliminate ~$500B of federal student loans was met with both celebration and criticism. Despite some legitimate concerns about the lack of fairness (across racial and socioeconomic lines) and the impact on inflation, I do believe some degree of student loan debt forgiveness is a necessary step given the financial trouble many young Americans find themselves in post-graduation. However, what I find far more concerning is the absence of substantive reform to fix the underlying problem — how we issue federal student loans in the first place.

The federal student loan program, in which the government guarantees higher education student debt, dates back to the 1960s. The goal was simple: provide capital, where it wasn’t readily available, to educate and upskill the broader population. This would, in turn, create a more productive and inventive workforce, and ultimately drive economic prosperity. And it worked — data from the World Bank show that from 1965 to 2000 the US GDP grew at 7.8% CAGR and per capita GDP (in today’s dollars) grew nearly 10x from ~$3,823 to ~$36,330.

However, guaranteeing college loans had unintended consequences.

The government guarantee, and in some cases direct lending, led to “cheap” loans. When coupled with the enormous social premium we as a society place on a college degree, these loans led to a steady increase in enrollment rates — immediate college enrollment (directly after high school) grew 50% from roughly 45% in the 1960s to 65–70% in the early 2000s. Universities saw surging demand and the cheap guaranteed debt fueling it as an opportunity to raise the cost of attendance. From 1963 to 2020 the cost of a four-year degree at a public institution (tuition, fees, room & board) soared from $9,380 (in today’s dollars) to $102,828. This was most acutely observed at private universities that invested heavily in degree proliferation, lavish facilities, and the “student experience” — from 2010 to 2020 private 4-year cost of attendance increased by 45% whereas the public 4-year cost of attendance grew by 16%.

The net impact of this is the higher education asset bubble we are living with today — and the $1.7T in debt our young people borrowed to pay for it. In the simplest terms, the price of the asset (cost of attendance) grew faster than the underlying asset value (future earning potential unlocked by the degree). While the announced debt relief addresses some of this historical mismatch, we have a far bigger and structural problem in how we issue student loans on the front end. Unless we fix this, once-off debt relief is no more than a band-aid solution.

A college degree is ultimately an investment in oneself.

You take out a loan to pay for the asset (education) with the belief that the asset will yield a positive return on investment (higher future earnings). And broadly speaking, this is true — the more educated you are, the higher earnings you are likely to enjoy. A 2017 BLS analysis showed that when compared to the earnings of someone with a high school diploma, the median weekly earnings for an individual with a bachelor’s, master’s or professional/doctoral degree was 1.7X, 2.0X, and 2.5X respectively.

The federal government however treats all these degrees and the colleges that issue them the same — as long as you are seeking a degree from an accredited higher education institution, you can get a loan. Said another way, the Federal Government assesses a dollar spent on a law degree at an Ivy League institution with the same risk profile as a creative writing degree from ‘State U’. This is fundamentally flawed — different degrees have different future earning profiles and should be assessed accordingly. In 2022, the average starting salary for a bachelor’s degree in engineering is $69,188 while visual and performing arts is $42,465[3]. The difference in lifetime earnings is even greater. Yet, for the most part, each university charges the same amount for tuition regardless of the degree chosen. As a result, millions of young adults start their careers with $100K+ in debt with a degree that has no reasonable ability to generate the income needed to pay back the loan.

The most important step in reforming the system is installing a standardized way to value a degree based on its underlying value.

In other words, we need to appraise the asset (the degree) based on the future earnings it can reasonably be expected to deliver for the borrower. This appraisal needs to be built into an actual loan underwriting process that makes a loan decision (yes/no, rate, terms, etc.) based on its unique risk profile (total loan amount v. expected income of borrower). Given the typical age of college loan borrowers (17–19), many of the traditional elements of creditworthiness included in an underwriting process such as credit score and employment history don’t make sense in the case of college loans. However, some argue elements such as high school grades should be included in evaluating risk.

One additional element of reform is improving future earning potential transparency.

Schools should publish data on graduating salaries and lifetime earnings for specific degrees and majors (this is something MBA programs already do particularly well). This way, students at the very least, can start to understand why they are seeing different loan terms for different majors.

Two final thoughts. First, the federal government is probably not best positioned to do the underwriting and risk assessment and that is OK. The government was never intended to be a direct consumer lender and existing private lenders already do this for home mortgages, car loans, and credit cards. Specialized private education lenders (e.g., Earnest, Sofi) are also popping up that are taking a fresh approach to educational loans and drawing on many of the elements described above.

Second, the reform will undoubtedly lead to higher interest rates and fewer loans approved for some college majors. This is also OK. The current lending regime, in which we value all degrees equally, has led to a skill mismatch in this country (nursing is a particularly good example). Let the free market sort this out — given today’s job market, the interest rate for a creative writing degree should be higher compared to that of a nursing or computer science degree. It also means, that overall college enrollment probably goes down as, in aggregate, interest rates go up and loan approval rates go down. This too is not a bad thing. As demand drops, basic laws of supply & demand suggest colleges will drop the cost of attendance.

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