Excessive Student Borrowing: Private Loans and Bankruptcy

(Photo by Flickr/CC user taberandrew)

Stories of students struggling under the crushing burden of $80,000 of debt or more for a bachelor’s degree that has yet to lead to employment are not representative, but they are more common than they should be. Virtually all students with so much undergraduate debt have relied on private loans, in addition to federal loans. Federal policy makers should move to end the confusion between these two forms of borrowing.

Many people believe that student loans are on the verge of ruining the economy, or at least destroying the lives of a generation. Others suggest that these students are simply irresponsible. Instead of taking either of these extreme perspectives, we should think carefully about the systemic problems contributing to this situation and potential policy changes that could make these circumstances fewer and farther between in the future.

A fundamental problem is that the category “student loans” is not limited to federally subsidized and guaranteed loans that come with limits on borrowing, identical terms regardless of a student’s credit history, and strong repayment protections. Instead, Congress has seen fit to define a subset of unsecured personal loans as student loans. These loans are not dischargeable in bankruptcy.

The role of bankruptcy in our financial system is to allow borrowers to get relief on reasonable terms when circumstances render them unable to live up to the terms of their agreements. It provides borrowers a chance to go on with their lives, although not without suffering penalties, and lenders to gain reasonable relief and move on in their businesses. Eliminating the option of bankruptcy substantially increases the power of lenders to press borrowers who lack much legal recourse. As a result, lenders have little incentive to deny credit to students who are highly unlikely to be able to repay their debts. But they do charge stunningly high interest rates to account for the risk they are taking. Labeling these loans as “student loans” conveys to young and ill-informed students the idea that these are “good” loans. Many do not know that these loans are very different from federal loans.

An obvious necessary step is to eliminate this privileged category of private student lending. Student loans should only include government-backed loans with special conditions for students. We subsidize these loans because students’ lack of collateral makes them poor candidates for standard private credit markets and because we have a national interest in increasing educational attainment among people without adequate resources to fund their studies up front. We should label and treat so-called “private” student loans as exactly what they are—unsecured personal loans. And like other such loans, they would be dischargeable in bankruptcy.

We of course can’t prevent students from supplementing their budgets with credit cards, bank loans, or any other problematic means of financing. But we can stop providing incentives for both students and lenders to engage in this questionable activity by giving the loans a misleading label and granting the lenders unusual collection privileges.

Even if we eliminate private student loans, we will still find some students borrowing excessive amounts of money to follow educational paths with low probabilities of success or with success leading to earnings likely to be insufficient to support the necessary debt payments—and no doubt some lenders will still be willing to give them credit. But eliminating these misleading labels and special protections for lenders will make these mistakes less common.

It is rare to find situations where it makes sense for students to borrow $80,000 or $100,000 for their undergraduate education. In most cases, they don’t have to do this. Many are enrolling in institutions that charge more and/or give less generous financial aid than other available options, succumbing to unscrupulous pitches from either for-profit or non-profit colleges and from profit-seeking lenders. We have to figure out how to discourage this sort of behavior.

There will always be wealthy parents who want to spend $200,000 to provide their children with four years of comfortable living while they study studio art or social work or elementary education. Some will think that it’s not fair that some young people have this opportunity and others don’t. But it’s even less fair to encourage less-privileged young people to incur excessive debt on bad terms that will burden them for years to come.

Instead of pushing panic buttons about student debt we should stop privileging private student loans and we should do a much better job of discouraging students from borrowing money just because it’s there in order to follow paths unlikely to pay off. We have a public system of postsecondary education that, despite the strain it is under, provides affordable opportunities for people to follow their dreams. That system needs more support. And we have a wide variety of educational paths with very high pay-offs—both financial and otherwise—for most students. It is vital that we make sure that adequate student loans—real student loans with government backing—are available to students for their basic educational needs.

Student loans open many doors for many students. We can’t and shouldn’t abandon them. But we have to deliver them more carefully.

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