Thursday, May 23, 2013

Student loan interest rates, collateral, and incentives

Xan had a nice follow up post  to my post on  the option value of attending college where he (partially) takes up the question of why people major in things that do not produce value for society.  It is an interesting perspective that you should read. This post tackles another angle of the value of college debate from recent weeks: student loan debt and things the government can do.

According to some sources, student loan debt is greater than $1 trillion, which ranks second to only mortgage debt when we tally the amount of debt held by U.S. consumers.  As tempting as it is, we should be careful in drawing comparisons to mortgage debt.  For one, the most important distinction between student loan debt and mortgage debt has to do with collateral.  What can the bank take away from the borrower if the borrower defaults on the loan obligation?  If you take on a loan to purchase a house, the bank or loan collection agency can take your house if you stop making payments.

In the case of student loans, the loan is used to invest in the student's human capital, thereby becoming part of the student.  This is not a bad thing per se, but banks need to have some assurance in the event that the student defaults.  It doesn't help that the investment becomes attached to the student, and thus, cannot be directly used as collateral.  The current alternative to collateral is wage garnishment, where the bank or federal government can recoup the loan by taking 10 to 25 percent of the student's wages until the loan is paid back.  This is some recourse for the lender, except that it depends on the student having a job, and it can result in much slower repayment.

Thus, student loan debt is riskier for the lender than a mortgage loan, and as a result, it should not be surprising that the higher-risk student loans have a higher interest rate.  After all, this is the primary cost of the loan, and from the standpoint of a bank, there is good reason to charge a higher interest rate if repayment of the loan is less likely.  Moreover, delinquent student loan repayment has been on the rise:

Two credit agency studied this week show that delinquency rates on student loans are climbing.
According to the more recent TransUnion study, more than half of student loans are in deferred status where the loan payment has been temporarily delayed. Deferred loans now represent 43.5% of all student loan balances.
Enter Elizabeth Warren who is proposing to reduce student loan rates, not to the same rate that home buyers get, but to the rate that banks get (which are even less risky than homeowners):

Warren views her proposed interest rates as a subsidy, as is evidenced by the interview in this article:
“Keep in mind, every time the Federal Reserve opens its window to let the largest banks borrow at [point seven-five percent] it’s not even scored on the budget—they are getting a subsidy. They get away with it, and it’s a subsidy that remains entirely hidden in the federal budget. But [for some reason] there is a resistance to give our kids some kind of break. Surely we care about our kids as much as our banks,” Warren said.
Even if you think that there are good reasons to subsidize higher education (one perspective, another), Warren's proposal will encourage students to take on more debt as they pursue higher education.  Moreover, it is not obvious that it is efficient to subsidize higher education beyond the current levels of subsidies.  To put it another way, here's the Daily Show's Aasif Manvdi:


Now, I'm not arguing that going to college is a bad idea, but to make the right decision, students need the right incentives.  There is some truth to Xan's point that college is an environment that tricks students into thinking that everything is low cost.  Artificially low interest rates won't help that perception.

2 comments:

  1. You are right in saying student loans are riskier than mortgage loans due to the lack of collateral with student loan. However, you can be relieved of all mortgage debt in a bankruptcy and student loans never go away, except upon your death.

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    Replies
    1. This is true, and I glossed over this point in the original post. From the standpoint of a bank, it is still risky to issue a student loan that could take a very long time to secure repayment. Collateral is much simpler than eternal wage garnishment.

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