We Can End the Student Loan Mess

By Diana Furchtgott-Roth, Jared Meyer

This month, as 1.8 million newly minted bachelor’s degrees are handed out, most graduates will be coming off the stage with much more than a fancy piece of paper. Seventy percent will take an average of $27,000 in student loan debt with them as they try to build their careers after college. 

This debt carries major consequences. One recent graduate, Annie Johnson, who is $70,000 in debt, told us this:

My student loan bills are nearly $900 a month. I see a quality-of-life difference between myself and my friends who do not have student loan debt. Saving is really hard when living expenses are added to my student loan payments. I know this is already setting me back in terms of retirement savings. My future options are limited since, in order to advance my career, I have to go back to school. But to go back to school, I would have to add to my debt.

This recent graduate is not alone. Almost 40 million people have student loan debt, which is the only category of household debt that continued to rise during the recession, and fifteen percent of borrowers default within the first three years. The 90-day delinquency rate on student loan debt is 11 percent. This is higher than the delinquency rate for residential real estate loans (3 percent) and the credit card delinquency rate (7 percent).

Since 2004, overall student loan debt increased by 325 percent, while all other categories of non-housing debt decreased by 5 percent. Over that time, the number of borrowers owing between $50,000 and $75,000 has doubled, and the number of borrowers owing more than $200,000 has tripled.

I Went to College for This?

The class of 2015 differs drastically from the class of 1993. In the early 1990s, fewer than half of students needed loans before they could walk across the stage to receive their diplomas. These loans averaged below $10,000 in constant dollars, which is about one-third of today’s average debt loan.

Student loan debt is much more difficult to repay when graduates cannot find jobs. Even though employment prospects for college graduates are better than those of non-graduates are, their futures are not always sunny. Over 8 percent of graduates younger than 25 are unemployed, compared with 3 percent of graduates older than 25. Before the Great Recession hit, only 6 percent of recent college graduates were unemployed. Back during the last year of the Clinton administration, this number was just 4 percent.

But the unemployment rate does not capture the full, bleak picture. Almost 44 percent of recent college graduates are underemployed, compared with 34 percent in 2001, according to the New York Federal Reserve. Now, over 115,000 janitors and a quarter of retail salespersons have college degrees. Is it any wonder that Wells Fargo found that one-fourth of millennials do not think college was worth the cost?

While some policymakers, including Senator Elizabeth Warren (D-MA), are pushing the government to forgive or refinance outstanding student loans, this would do nothing to stop the real driving force behind skyrocketing student loan debt—the increase in college tuition. College tuition has increased by 1,180 percent since records began in 1978—while food costs have risen only 240 percent over the same period.

Washington Increases the Cost of College

In our new book, Disinherited: How Washington Is Betraying America’s Young, we argue that outstanding student loan debt in excess of $1 trillion requires those in Washington to think beyond ordinary solutions and to put everything on the table—including the $165 billion that the federal government spends annually on its college grants, student loans and tax credits. Though well intentioned, instead of making college more affordable for low-income students, these programs create incentives for colleges to increase their costs.

The U.S. Treasury Department found that for every dollar provided in tax-based aid, scholarships fell a dollar. Automatically providing student loans through the government (as the system has worked since 2010) or offering loans at low interest rates subsidized by the government increases the demand for college education. These low rates allow schools to raise tuition costs exponentially—and they have been doing just that.

The federal loan program is best understood as an individually tailored subsidy for each school, because loans are awarded based on how much it costs to attend a given college. The more a college raises its tuition, the more loan money the government will make available to students for tuition. This is termed the “Bennett hypothesis,” after former Secretary of Education William Bennett.

Currently, all direct undergraduate federal loans carry the same interest rate of 4.66 percent—regardless of borrowers’ past academic performance, choice of school and field of study, and future career prospects. Varying the interest rate with a combination of these crucial indicators would provide an incentive for students to pick schools and majors that better fit their skills, potential and ability to repay.

Though Washington does not have a proven track record of correctly setting interest rates, reforms in this direction would help to reduce the amount of student debt, increase the number of graduates, and lead to higher repayment rates. Rates that vary based on possibility of repayment serve as important signals to perspective students—and as a way to hold colleges accountable for their students’ futures. The current one-size-fits-all interest rate coveys the same signal to each student, even though the right type of education differs drastically from person to person.

There’s a Way Out of This Mess

Some innovative private companies already realize this reality. Upstart and Pave, a new breed of lenders, provide a technological platform that allows those with available money to invest in young people and their human capital. With these lenders, investors are repaid through percentages of borrowers’ monthly salaries for a period of up to 10 years following graduation. To determine individual rates (usually between 4 percent and 7 percent of incomes above a certain threshold); companies calculate likely future earnings based on university, major, grades and professional experience.

With this business model, students have an economic incentive to choose degrees in high return, in-demand majors such as engineering or computer science, because it means their repayment will be a lower percentage of their future salary. Investors also have incentives to mentor those in whom they have a financial stake, which helps young people to succeed. If the loan recipients’ careers take off and their salaries increase, the investors’ returns rise.

Until the underlying reason for increases in college tuition is addressed, student loan burdens will only continue to grow. In a time of high under- and unemployment among college graduates, artificially increasing the costs of college though the current system of federal student aid programs leaves many graduates hopeless and suffocating under heavy debt.

Diana Furchtgott–Roth is a senior fellow at the Manhattan Institute and a columnist for RealClearMarkets.com.Jared Meyer is a fellow at the Manhattan Institute.