Here is one of the basic problems facing the complex student loan situation in the United States: private lenders are generally unwilling to provide loans to young, zero- or low-income people that are only secured by future earnings. Susan Dynarski and Daniel Kreisman of the University of Michigan describe this as a failure of the capital market, one of the ways in which the normal market mechanism has difficulty satisfying a social need (that is, affordable financing for higher education).
In a paper published by the Hamilton Project, Dynarski and Kreisman point out the basic forces at play here. Young people, typically, have nothing: no or little income, no or little capital, and no or little skills required to get a well-paying job. With a high school diploma in hand, the nation’s young adults are generally faced with this choice: invest in a college education, or enter the workforce.
College is not the right choice for everyone, but there is no hiding the fact that education is increasingly important in the modern workforce. Those looking to find well-paying work — or even any work at all — are much better off with a college degree. Data from 2012 show that there was an 8.3 percent unemployment rate among high school graduates with no college education, and a 4.0 percent unemployment rate among those with a bachelor’s degree or higher. This compares against an average headline unemployment rate of 8.1 percent.
Education is a path to acquiring the skills and experience that people need to effectively participate in the labor force (or, compete in the labor market), and despite some pessimistic headwinds most people still believe a college education is a worthwhile investment. Dynarski and Kreisman suggest that those with a college degree can earn hundreds of thousands of dollars more over their lifetimes than those without a degree, a sum that is far larger than the $50,000 or less than 98 percent of students borrow to finance their education.
At arm’s length, this is a good return on investment. The problem, though, is that most students find it incredibly difficult, if not impossible, to pay back their loans on the ten-year schedule that is mandated by most loans. New graduates are asked to begin paying back their loans after a period of just months when they are at perhaps the most financially unstable time of their lives. Youth (aged 16-24) unemployment in July was 16.3 percent, and those who were employed could look forward to an average weekly earnings of about $436.
Unsurprisingly, this mix has contributed to a spike in student loan defaults. Students who were encouraged — compelled, even — to invest in their education on borrowed money were thrust into one of the most challenging labor markets in generations and told to start paying up. Defaults are now up to 21 percent as students fail to make payments that can amount to huge percentages of their total income.
It is important to understand what, exactly, is wrong with this system (at least, according to Dynarski and Kreisman). It is not that students are borrowing so much to go to college, its that repayment expectations are unreasonable. Borrowers are asking for too much, too fast.
Dynarski and Kreisman found that the average balance of a loan in default was just $14,000, while the average loan not in default was $22,000. About 69 percent of students who borrowed to go to college borrowed less than $10,000, while 29 percent borrowed between $10,001 and $50,000. That’s 98 percent of all student borrowers who borrowed less than $50,000. This is a lot of money, sure, but far less than the expected income windfall over the course of the student’s lifetime as a result of the education.
“For most types of borrowing, the life of a loan matches the life of the collateral, but the relatively short repayment period of a student loan does not match the lifetime of increased earnings,” states a Hamilton Project policy report on the paper. ”The mismatch between the timing of the costs and benefits of education is especially salient among young borrowers, who are most likely to default.”
The solution, then, is this: a flexible, income-based repayment schedule. The policy report explains the researcher’s proposition. ”The authors propose a progressive system of loan payments that rise with earnings. Specifically, they show that setting rates at 3 percent of earnings up to $10,000, 7 percent between $10,001 and $25,000, and 10 percent above $25,001 would result in the typical loan being paid off in ten to fifteen years, with some loans paid much more quickly. A flat contribution rate of 6 to 9 percent of earnings would achieve similar results.”
The researchers recommend that — much like the system recently put in place by Congress — that the government issue student loans at a market-based rate plus some premium to cover risk of default (which should be dramatically reduced in this situation) and administrative costs. ”Under the proposed income-based repayment system, interest rates would be set so as to hold taxpayers harmless for the costs of making student loans,” states the policy brief.
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