Why Student Loans Have Grown Into a Policy Debacle

Published September 17, 2013

Since 1965 Congress has provided more and more students with subsidized loans to finance their college educations, all with the best of political intentions. As of mid-2013 the average student debt of college graduates stood at $26,600, with 10 percent of students having student loans of more than $40,000 and 1 percent of students having loan debts of more than $100,000, according to the Institute for College Access and Success.

Total outstanding federal student loans now exceed $1 trillion (with an additional $200 billion in student debt from private sources). With the continuing anemic economic recovery, many unemployed (or underemployed) graduates have begun to default on their loans. One third of federal students loans are in deferment, forbearance or default. This means many graduates’ credit ratings have been (and will be) undermined by the enticement of subsidized student loans.

Congress this summer rescued many graduates by lowering a scheduled increase in the interest rate student debt holders would have to pay on their loans. As of this writing, the interest rate on student debt has been tied to the interest rate on U.S. Treasury bills, which means student loans are still subsidized.

Many pundits and politicians have favored subsidized student loans on the grounds that they enable more people to become college graduates and enjoy a career income trajectory that is higher than that for high school graduates. The presumption has been that college graduates would capture the government largesse. However, others also have siphoned off the money.

More Loans, Higher Prices

Because student loans have increased the demand for higher education, colleges and universities have been able over the last two decades to raise their tuition and fees at rates far above the inflation rate. From 1990 until 2011, the inflation-adjusted average price of a four-year education from a private university rose by 49 percent; from a public university, by 84 percent.

In short, a nontrivial portion of the student-loan subsidies has gone to professors and administrative staff members (which is one reason they support the growth in student loans). Another portion of the student loans has gone into upgraded dormitory suites with many of the amenities of home and more, including fully equipped gymnasiums, salt-water pools, climbing walls, and pubs on campus.

Subsidized student loans have also contributed to the growing employment problems of college and university graduates in a couple of unrecognized ways. First, the loans have increased the labor-market supply of graduates, lowering their bargaining power and forcing many graduates to accept jobs that do not require a college degree.

Second, the subsidized loans have induced more marginally qualified students to go to college and undertake courses of study that are not demanding. The growing number of graduates who have taken easy courses or not taken their school years seriously has undercut the value of higher education, especially at colleges and universities that have lowered their academic standards.

Easy Loan Diversions

Student-loan supporters have assumed student loans are used solely to finance students’ college educations. However, loans are almost as fungible as money, which means the funds can easily be diverted to other purposes. Consider a family with a son or daughter entering a university as a freshman. Suppose the parents are also planning to buy a new car. They have savings sufficient to pay for a year of college or the upscale car. They can’t do both. What should they do?

With the student-loan interest rate set at several percentage points below market rates, some parents can be expected to take out a subsidized student loan. They can then use their own funds to buy the car. This means the loan has effectively enabled the parents buy the car at a cheaper price than otherwise, with the interest subsidy being covered (unknowingly) by taxpayers.

The parents can follow this ruse for four years. One year they can use the student loans to finance home renovations. The next year they can use the loans to buy a boat or to make the down payment on an off-campus condo with upscale amenities that can’t be found on campus. All of this financed partially by taxpayers.

Outright Fraud

This type of scheme is not even included in the overtly fraudulent student-loan rings that are periodically assessed by audits. A new report by the Office of the Inspector General identified more than 85,000 student loan recipients who may have been using their funds illegally by obtaining student loans in other people’s names or by fabricating attendance at college. This fraudulent use of student loan funds ended up costing the taxpayers $187 million from 2009 to 2012. When coupled with parents buying cars and boats, taxpayers are effectively financing significant activities outside of education.

When pushing new student loan legislation, politicians should be mindful of the unintended consequences of subsidized interest rates. Student loans have contributed to rising tuition costs and unemployment among college graduates, which have increased student indebtedness. Many parents are potentially using the low interest rates to finance additional purchases that have at best a remote connection to “education.” And overt fraud is prevalent and growing rapidly, costing taxpayers additional millions of dollars.