The Real Problem With Student Loans

Suppose you want to make an investment in a long-term asset that pays off over the next 45 years. You go to the bank and ask for a loan to pay the up-front cost of the investment with the promise to pay the funds back once the asset begins paying returns.  The bank offers to loan you the funds at an interest rate of X% that reflects the risk-adjusted cost of making the loan based on the riskiness of the asset and your likelihood of repayment.

In any normal context, you would look at the interest rate, look at the expected payoff of the investment, and determine whether or not the investment still made sense given the cost of borrowing the money. If the cost of the loan to make the investment was higher than the expected payoff, then you would either seek a cheaper loan or you would forgo the investment.

That is, unless it’s a student loan. And THAT is why we have a student debt problem.

DISCLAIMER: I am a college professor and a parent of a soon-to-be college freshman (the first of three children to hit that stage). So yes, I get the whole going to college thing and I understand the limitations of an 18-year-old’s ability to see the future and think through the problem. And no, that’s not an excuse for the excessive amount of student debt accumulated in the US.

The Obama Administration has proposed expanding its current income-based repayment program, which effectively allows students to pay back only a portion of their student loans with no consequence to the borrower and no regard to the amount of the loan outstanding, provided they keep up on their minimum payments for 20 years (10 years if working for a non-profit or for government).

This program creates ridiculous incentives, both in terms of the amount of debt accumulated and of biasing the labor market to encourage college graduates to forgo private-sector, for-profit employment in favor of working in the public sector. Because repayment is limited to a small portion of income (10% of net take-home pay less basic living expenses), students have no incentive to limit the amount they borrow to be in any way reflective of the earning potential of their degree. And because graduates who work in the public sector only have to make their minimalist payments for 10 years rather than 20, newly-minted grads have an incentive to avoid private-sector employment in favor of public (i.e., government) jobs.

For instance, someone majoring in elementary education, with an average starting salary of $31,400 in 2013 according to Payscale.com, has no less incentive (and perhaps even more!) to invest in a $200,000 college degree than does a student in Finance ($47,700) or chemical engineering ($67,500). Take into account the difference in future pay-offs (mid-career salaries for the three are $46,000, $85,400, and $163,000, respectively), and it becomes even more clear that what might be a reasonable up-front investment for an engineering student makes little sense for a would-be teacher.

It’s difficult to imagine any reasonable argument for spending as much for a $32,000 per year job as for a $67,000 per year job. And yet, the Obama Administration’s proposal would reward even more people for making such “investments” by choosing more expensive schools and programs without a commensurate increase in expected earning potential. Add to it that in the example above the teacher would only have to pay on their loan for 10 years while the finance and engineering professionals would have to pay for 20, and it makes the initial outlay of educational expenses even more distorted. (Granted, the engineering student would likely not even qualify for the program…meaning she would pay the loan back in full herself rather than dumping her choice of colleges on taxpayers.)

At the height of the housing market troubles, banks were being castigated for encouraging home buyers to buy homes they could not afford. In the case of student loans, colleges and universities are engaging in no less an abuse of subsidized lending practices to pad their tuition coffers. Colleges and universities are well-aware of average starting salaries in different majors. Financial aid officers know—or should know—the financial burden that graduates from their school will face. Perhaps rather than creating an even larger disconnect between the cost of higher education and the responsibility for paying it, more attention should be given to helping students understand whether their investment in a particular college or major is a financially responsible one.