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Student Loan Borrowing Is Different

posted by Adam Levitin

Education finance and student loan forgiveness have been getting a lot of attention the last couple of days because of our former co-blogger's loan forgiveness proposal.  I'm not going to address the merits of that proposal here.  Instead, I want to make a simple point that many of the critics of Senator Warren's proposal don't seem to understand:  student loan borrowing is materially different from other types of borrowing, such that the borrower has no idea what s/he is getting into.

When I borrow to buy a car or a home, it is a one-and-done deal with a single loan product.  With the car or home, I also know what I’m getting and I know what it costs.  These aren’t perfect markets, but the work on a broad level.  Education finance does not.  That’s why criticisms of student debt relief plans that claim that borrowers know what they’re getting into or the sacredness of the contract just irk me.  Student borrowers have no clue what they’re getting into and if a party doesn’t really understand a deal, it’s hard to see why it should be treated as sacrosanct. (Not to mention, as any good bankruptcy lawyer knows, basically all deals are made subject to the possibility of a bankruptcy discharge.). There is a fundamental market failure in student lending and that is that borrowers simply don't materially understand the nature of the obligations they are assuming...and probably can't.  

I think it’s worth spelling out why student loan borrowers don’t understand what they’re getting into.  Consider, with a car loan or a mortgage to finance a home purchase, I borrow a single time, with one loan from a single lender.   That alone makes it a much simpler transaction than education finance.  For education finance, I am undertaking fresh borrowing every year along the way to may degree. Moreover, with education finance, I’m not just getting a single loan from a single lender.  I’m probably getting a complex financing package:  I can get a Direct Subsidized Loan from ED for $5,500/year.  I can add to that a Direct Unsubsidized Loan from ED for another $25,500.  If a parent is willing to go on the hook, they can help me out with a PLUS Loan from ED.  And if that’s not enough, I can get a private student loan.  This means many borrowers have two, if not three or four loans each year for their undergraduate education.  (A similar phenomenon exists for graduate education, but financing there is a little different.). 
What’s more, when I take out a car loan or home mortgage I get an extensive set of upfront disclosures under the Truth in Lending Act.  These disclosures tell me in clear, relatively easy to compare terms how much I’m financing, what the finance charge is, and what the annual percentage rate is.  The finance charge and APR are meant to be more-or-less all-in-costs of borrowing.  I get these disclosures before I commit to the transaction.  In contrast, with a Direct Loan, I don’t get any TILA disclosures.  Instead, I get some paperwork when I agree to the loan, but it isn’t disclosing the “finance charge” or APR.  It tells me the “interest rate,” a term, not defined by ED regulations.  Omitted from that interest rate is the up-front 1.066% fee ED takes out of every loan, reducing the disbursement.  That would be part of a finance charge if TILA applied, but because it’s not ED gets away with appearing to have cheaper loans. ED gets to do a type of partitioned pricing that regular lenders cannot.  (The fee is much larger for PLUS loans, furthering the distortion there.). 
With a car loan or mortgage loan, I will know my monthly payment before I get into the loan.  This is often the most important thing for a consumer because it is the debt service, not the total debt stock that really affects immediate consumption ability.  With a Direct Loan, I will not know my monthly payment until 30-150 days before my first payment is due.  In other words, I will not know my monthly payment until after I have graduated.  Yet for Direct Unsubsidized Loans, interest has been accruing from day 1.  By the time I learn of my monthly payment, it’s too late.  There’s no rescission right.   Moreover, critical differences between loan programs and the way forbearance and deferment work are unlikely to be understood by borrowers when they take out the loans.  
Additionally, with a car or home purchase, I know what I’m getting pretty well.  I get to test drive the car.  I get to conduct an inspection of the house.  I know what the car is capable of doing, and I know its gas mileage.  I can probably get a good idea of the utility expenses for the house, and I can see the condition of major appliances and systems.   In contrast, with an education, I do not know what I’m getting.  I can learn a fair amount about a school before I borrow, but I don’t know what my major will be, etc.  That’s like committing to buying a Honda, but not knowing if I’m getting a motorcycle, a Civic, an Accord, an CR-V, or a Pilot, much less what trim, etc.  I might be able to know that engineering majors make more than poetry majors on average, but there’s a good chance I have never taken an engineering class, so I can’t really evaluate if it’s for me.  In contrast, I can tell if a motorcycle is my kind of thing or not before I borrow for a car purchase.
Now add into this that the borrower is making the borrowing decision when the borrower is just barely of majority or perhaps not even.  18-year olds are just entering the financial world and have no experience doing major transactions.  We don’t let 18 year olds get credit cards unless they have independent means of repayment or a co-signor, but we’ll let them get $26,000 or more into debt without any meaningful counseling.  If the students I’m familiar with are any indication, even very smart, sophisticated students are woefully under informed about their job prospects.  My Consumer Finance class today was utterly stumped when I asked them about average income for attorneys.  Sure, they might have an idea about some specific positions, but there was no sense of what sort of income opportunities on has with a JD in general.  They were even more shocked when I took them through the calculation of what a borrower who maxes out on Direct Loans will owe 6 months after graduation from a 4-year college (when deferment ends).  The borrower will have received around $103k, but will already owe about $115k.  They were similarly shocked by the calculation of the monthly loan payment for such a borrower (around $425).  
I know I had no clue about what different professions made when I took out student loans to pay for college.  And I had no idea what I would major in or what I would end up doing with myself.   And I had very little sense of costs of living.  So even if I had the full information about loan costs, I wouldn’t have been able to make a meaningfully informed decision about whether to incur the debt because I wouldn’t have had any idea about my ability to repay.  Consider, if you told an 18 year-old that she would have $100,000 in debt for her undergraduate degree, what would that mean to her?  The figure looks large, but unless that 18-year-old has a good sense of the cost of living and her likely future income and the monthly payment burden from that $100,000, the sum figure is fairly meaningless.  
All of this suggests to me that federal student loan repayment should be entirely income-driven. And it suggests that private student loans are a particularly problematic market, in that they don’t in any way reflect borrower ability to repay (and likely can’t even use school or major as a proxy given the probability of ECOA violations). 
So bottom line here is that arguments that students know what they’re getting into or have some sort of moral obligation to repay just don’t hold a lot of water.  Student borrowers really don’t understand what they’re getting into, and accordingly it’s hard to see any compelling moral case for demanding their repayment.  At best, I think the case against loan forgiveness is a complaint about cross-subsidization, but we do that all that time.  There’s positive social externalities from increasing higher education, which makes it seem a lot more appealing to subsidize than some tax expenditures (e.g., certain agri-business subsidies) that lack any obvious positive social externalities.  And there's also a huge constituency for student loan forgiveness besides borrowers---homeowners.  Want to boost home prices?  Get rid of student loan debt and that will put a whole bunch of folks into the ownership market with upward ripples through the economy.  This isn't trickle down.  It's ripple up.  


The other aspect that has to be factored in is the feedback loop between student loans and college costs. It's a dilemma, because loans make college accessible for more students, but they also blunt or eliminate any economic incentive for colleges to keep costs down. What do we think would happen to the price of any other product or service if (a) the government was giving money to customers to buy your product without regard to the customers' creditworthiness, (b) if you raised your price, the government would give your customers more, or would at least lend more to your customers' parents to buy the product for them, and (c) you have no risk of being stiffed by a customer because the government backs the loans and they can't be discharged in bankruptcy.

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