Risk-Based Student Loans
Seton Hall Law School; Harvard Law School - John M. Olin Center for Law and Economics
September 5, 2011
Washington and Lee Law Review, Vol. 70, No. 1, p. 527, 2013
Credit markets serve a vital function in capitalist economies: evaluating the riskiness of a range of possible investments and channeling resources toward those investments that investors believe are most likely to prove successful. This process is known as the “risk-based pricing” of credit. Ideally, risk-based pricing should lead to lower cost of capital for lower risk investment choices with larger rewards, and therefore more investment in such promising activities. Conversely, risk-based pricing should lead to higher costs of capital, and therefore less investment, in high-risk activities with relatively low rewards. If creditors are well informed and analytic, and borrowers respond to financial incentives, then risk-based pricing — compared to uniform credit pricing — leads to a more efficient allocation of society’s limited resources.
Although risk-based pricing is standard in business loan markets, and may be increasingly common in consumer credit markets such as mortgages and credit cards, risk-based pricing is seldom used in the market for student loans. Most student loans are extended under Federal Student Loan programs administered by the Department of Education. These federal programs have historically offered loans at rates lower than those offered by most private lenders, on terms that are more attractive to student borrowers, and without adjusting the pricing on loans according to the risks inherent in different courses of study or lending to different types of borrowers.
The Federal Student Loan programs — first established in the mid twentieth century to increase the supply of skilled labor, promote economic and technological development, and provide upward socio-economic mobility — are broadly successful: they have provided low cost credit to millions of students; helped increase educational attainment; held administrative costs to below those of the private sector; and generated a profit for the federal government.
However, Federal Student Loan programs have not incorporated many recent insights from financial, developmental, and labor economics that distinguish between different types of education. Because of this, Federal Student Loan programs, and more broadly, U.S. labor markets, are not performing at their full potential. There is a large mismatch between the skills workers have and employers’ needs, and this mismatch contributes to structural unemployment, reduced output, and higher student loan defaults.
This article argues that introducing risk-based pricing in federal student loans would advance the interests and values that Congress articulated when it first established Federal support for Higher Education. Risk-based pricing of student loans would signal the long-term financial risks inherent in different courses of study. This price signal would likely improve students’ ability to make informed decisions about the course of study that would best balance their innate abilities and individual preferences with postgraduate economic opportunities. Similarly, price signals would enhance post-secondary educational institutions’ ability to adjust their programs to improve their students’ postgraduate prospects.
Allocating educational resources more efficiently would not only benefit individual students and their families — it would enhance the productivity and competitiveness of the U.S. labor force, with beneficial consequences for both the private sector and public finances. Over the long term, such efficiencies could increase the resources available for further investment in education and research.
Transparent, risk-based student loan pricing could greatly benefit students and educational institutions, particularly if it were data-driven and sensitive to the values of equal opportunity and independent research that are central to the academic enterprise. This article discusses legal and policy reforms that could facilitate risk-based student loan pricing, potential hazards from a shift toward risk-based pricing, and safeguards that could help protect students and educators from abuse.
This article focuses primarily on the economic consequences of education rather than on moral or philosophical views about the ideal purpose of education or its proper role in society. The economic focus of this article is not intended to deny the intellectual merit of philosophical views about education, but rather to reflect the fact that government support for Higher Education in the United States has primarily been driven by economic considerations, particularly during the mid-twentieth century when Federal Student Loan programs were established.
Part I of this article discusses rationales for government support for higher education, with an emphasis on human capital theory. Part II discusses the U.S. federal student loan system. Part III discusses coordination, information, and incentive problems in the higher education and skilled labor markets. Part IV explains the theory of risk-based credit pricing and how risk-based pricing of federal student loans could ameliorate some of the coordination problems discussed in Part III. Part V discusses predictors of income, employment, and student loan default, and also considers ethical and moral considerations that might limit or preclude the use of certain predictors to risk-adjust student loan pricing.
A powerpoint presentation based on this article is also available at: http://ssrn.com/abstract=2121096.
Number of Pages in PDF File: 122
Keywords: student loan, consumer credit, labor market, structural unemployment, cob web cycles, active labor market policies, risk-based pricing, risk based pricing, education, bankruptcy, human capital
JEL Classification: D13, D31, D61, D63, D82, G14, G18, H4, H52, H81, I2, I22, I28, J24, J21, J23, J62, J64, J68, O12, O1
Date posted: December 8, 2011 ; Last revised: May 5, 2013