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Brq313 Economics of Student Loan Borrowing and Repayment

Brq313 Economics of Student Loan Borrowing and Repayment

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Business Review
Q3 2013 1
www.philadelphiafed.org
eports in the popular press andpolicymakers’ concerns about student loanshave greatly intensified in recent yearsbecause of rising student loan balancesand defaults. Even greater cause for concern aroseas student loans outstanding passed credit card debtto become the single largest nonmortgage householddebt in 2012. Worries about the risk of massive defaulthave even prompted a comparison with the subprimemortgage crisis.
1
 
The Economics of Student LoanBorrowing and Repayment
BY WENLI LI
Existing theoretical and em-pirical work by economists on studentloans can shed light on the econom-ics behind this trend and, therefore,help provide answers to a number of important questions: What determineswhether and how much a householdborrows for student loans, and whatdetermines whether and when a house-hold repays these loans? What factorsaccount for the widely noted increasein student loans outstanding anddefaults? What are the implications of the trend for households’ consumptionand for the broader economy?
A SIMPLE THEORY OFSTUDENT BORROWING ANDREPAYMENTWhat Makes Student Loans Dif-ferent
? Student loans are made solelyfor the purpose of financing highereducation; that is, they are designed tohelp students pay for college tuition,books, and living expenses. They aredifferent from other consumer loans,including credit card debt, auto loans,or mortgages; for those types of loans,households borrow to purchase goods
1
For example, Steven Eisman titled his presen-tation on student loans at the Ira Sohn Confer-ence “Subprime Goes to College.”
Wenli Li
is a senior economic advisor and economist at the FederalReserve Bank of Philadelphia. The views expressed in this articleare not necessarily those of the Federal Reserve. This article andother Philadelphia Fed research and reports are available at www.philadelphiafed.org/research-and-data/publications.
they consume immediately, such asclothes, a car, or a house. Economistsoften view student loans as a means of financing investment in human capi-tal. In other words, student loans helpborrowers, through their college expe-rience, to acquire knowledge as well associal and personal attributes that mayenhance their ability to later performin the economy and, thus, gain higherearnings.
2
It is in this sense that stu-dent loans are analogous to investmentin physical capital such as an MRImachine purchased by a clinic. Unlikea pill given to a patient, the machineis not consumed immediately; rather itis used for future production (scanningpatients), and with each use, it gener-ates income from the fee a patient paysfor each test.
 Both Supply and Demand Fac-tors Affect Student Borrowing.
Ahousehold’s decision to take out astudent loan — the demand side — isobviously tied to its decision aboutwhether to attend college. The major-ity of people in the U.S. go to collegeshortly, if not immediately, after highschool. These people are often in theirlate teens or early 20s and lack thefinancial resources to pay for college,even with the help of their parents.Therefore, they need to borrow tocover the cost. Put simply, for a largefraction of the U.S. population, thedecision about whether and when totake out a student loan is closely tiedto the decision of whether, when, and
2
Of course, education serves other importantpurposes that are not captured by a narrow lookat graduates’ earning power, but in this article Ifocus solely on the economics of student loans.
 
2 Q3 2013
Business Review
www.philadelphiafed.org
where to attend college. As a matterof fact, according to the
Chronicle of Higher Education
, about 60 percent of Americans who attend college borrowannually to cover costs.As with any other economic deci-sion, the decision of whether, when,and where to attend college dependson the difference between the benefitsand the costs. The economic benefitsof going to college are captured by thegain in future earnings, and the costsinclude the earnings a student forgoeswhile in school, in addition to tuition,books, and living expenses. Describedthis way, the prospective student’s de-cision sounds very simple. But even if we imagine, as most economic analysesdo, that the student has the ability torationally calculate costs and benefits,the decision is actually fraught withuncertainty.First, think about costs. Whilesome of the costs — tuition, books,and living expenses — are imme-diately observable and are relativelyeasier to calculate and predict over,say, a two- or four-year period, real bor-rowing costs may fluctuate as interestrates and inflation rates fluctuate. Inaddition, students’ forgone earningsmay be very difficult to measure withany precision. The income gains froma college education are entirely in thefuture and need to be estimated and,thus, can be very imprecise. For exam-ple, a computer science major not onlyneeds to figure out job prospects andprevailing salaries in four years’ time,but he must also project job prospectsand wages over the rest of his workinglife. To complicate the matter further,he also needs to factor in the possibil-ity that he may end up disliking thefield and taking up a different careerwith lower potential earnings.The lender’s decision — the sup-ply side — would be relatively simple if students borrowed in a perfect capitalmarket. The concept of a perfect capi-tal market is an ideal benchmark usedby economists, in which many real-world difficulties are assumed away.The concept is useful because it forcesus to think carefully about the factorsthat may limit a student’s capacity toborrow. In a perfect capital market,lenders can sign a contract that makesthe payments conditional on borrow-ers’ future earnings and can at no costto themselves compel borrowers towork and earn enough to repay theloan. The factors that affect a lender’sdecision about whether to extend astudent loan will thus be the opportu-nity cost of the funding (the interestthe lender could have earned on otherloans) and the riskiness of the gains(mainly due to the uncertainty aboutthe borrower’s income).Two factors complicate our idealworld. First, human beings, not ma-chines, are the ones producing earn-ings. In a civilized society, humanscannot serve as collateral becauselenders cannot enslave borrowers, norcan they buy and sell them.
3
Second,although lenders can garnish borrow-ers’ earnings when borrowers do notmake payments, borrowers’ earningsalso depend on their effort. This isvery different from machines, whosevalue depends mainly on their resalevalue, which is largely outside thecontrol of the owners who use it as col-lateral. For example, a computer soft-ware engineer living in New Jersey cango to work for an investment house inNew York City and make $60,000 a year with a commuting cost of $8,000a year, or she can work for $50,000 fora local firm that has better work sched-ules and does not require any com-mute. Suppose the engineer has to givehalf of her income to the lender to ser-vice student loans. In the first case, itmeans that the engineer pays $30,000to the lender and has $22,000 for her-self after taking out commuting costs.In the second case, it means that theengineer pays $25,000 to the lenderand the same amount to herself. Theengineer will choose to work locally,since she makes the same amount of money in either case, but the lenderwill lose $5,000 if the engineer choosesto work in New Jersey rather than inNew York City.Over the years, the federal gov-ernment has become the dominantsupplier of student loans, first throughits loan guarantee programs and morerecently through direct loans.
4
 
TheStructure of the Student Loan Market
 provides a brief discussion of the role of government in the student loan mar-ket. Therefore, a full account of thesupply side of the market would requireus to discuss the underlying politicalforces, since the total loan amount andinterest rates are set by Congress. Thatis beyond the scope of this article.
The Repayment Decision.
Thestudent loan payment decision, like allother consumer loan payment deci-sions, depends on the borrower’s abil-ity to pay and the costs and benefitsassociated with default. The ability topay depends on the borrower’s in-come and assets. If a borrower loseshis job or suffers a big loss in the stockmarket or a decline in the value of hisprimary residence, he may not be ableto service his debt. The benefits of notpaying one’s student loans are the re-sources that are freed and that can beused for consumption purposes or toservice other debt. Felicia Ionescu andMarius Ionescu show that households
3
Prior to the mid-19th century, debtors’ prisonswere a common way to deal with unpaid debt.The father of the British writer Charles Dickenswas sent to Marshalsea debtors’ prison. As aresult, Dickens used Marshalsea as the modelfor debtors’ prison in his novels.
4
Prominent arguments for government involve-ment are that social returns to education aregreater than private returns. Furthermore,employers tend to underinvest in generalizedtraining, since they do not fully capture thereturns in the event the trained employees leavethe firm.
 
Business Review
Q3 2013 3
www.philadelphiafed.org
have incentives to default on studentloans first, before defaulting on creditcard debt. By keeping their credit cardaccount current, they can continue touse it as a transaction account or forborrowing purposes. Economists callthis phenomenon “preserving liquidity.”The benefits from defaulting onstudent loans are, by contrast, limited.Unlike credit card debt, car loans, andother consumer loans, student loanscannot be discharged or reduced by ajudge (known as “cramming down”)under personal bankruptcy. Instead,borrowers who are late with theirfederal student loan payments have toenter into a repayment plan that canlast 10 to 15 years, and during thattime, a fraction of their earnings will begarnished, similar to what occurs in aChapter 13 repayment plan under per-sonal bankruptcy. The government can
5
It is likely that those who default on studentloans will suffer a larger effect related to accessto credit than bankruptcy filers. Bankruptcywipes out some or all of a borrower’s exist-ing debts, a situation that is attractive to newlenders, who will not have to compete with oldlenders to be repaid. But default does not wipeout student loans.
6
The calculation is based on a 1 percentrandom sample of the FRBNY Consumer CreditPanel, while the panel accounts for about 5percent of all households that have files withthe credit bureau.
7
Although car loans are also collateralized, carsdepreciate much faster than houses. For mostcar loans, the resale value of the car is not theprimary determinant of the loan terms.
The Structure of the Student Loan Market
T
here are three types of student loans: federally guaranteed loansmade by banks and other lenders; federal loans made directlyby the government; and private loans, which are essentially thesame as other consumer loans from banks and companies. Inthe case of guaranteed loans, the government pays a subsidy tolenders that make the loans and also guarantees the amountloaned.*Effective July 2010, in response to the changing market and the debateabout the federal government’s role in supporting student financing, Congressexpanded federal aid to college students while ending federal subsidies to privatelenders through loan guarantees.The interest rate paid by students on both guaranteed loans and direct loansis fixed and set by Congress. The government pays the interest that accrueswhile the borrower is in school. Congress in 2007 temporarily reduced interestrates for low- and middle-income undergraduate borrowers to 3.4 percent from6.8 percent until July 1, 2012. Congress then extended the freeze in interest ratesuntil July 2013, at which time it pegged rates to the 10-year Treasury yield.Private loans usually have worse terms than either type of federal loan, andinterest rates on private loans can change over time. Because most students havelimited credit histories, private lenders often require cosigners. The borrower isresponsible for paying the interest that accrues.
* The top 10 holders of government guaranteed loans (FFELP loans) in the third quarter of 2010were SLM Corporation, Nelnet, Wells Fargo, Brazos Group, JPMorgan Chase Bank, the Penn-sylvania Higher Education Assistance Agency, College Loan Corporation, CIT, PNC, and GoalFinancial. SLM Corporation had the largest market share (close to 60 percent), and each of theother institutions had under 10 percent of the market share.
also garnish the borrower’s tax returnsand benefits. Other costs of defaultingon one’s student loans include limitedfuture access to the credit market, sincethe borrower’s decision to default willaffect his credit score from the creditbureau. Evidence from bankruptcy fil-ers may give some sense of the order of magnitude of these costs. For instance,using data from the Federal Reserve’striennial Survey of Consumer Finances,Song Han and Geng Li find that bank-ruptcy filers are more than 40 percentless likely to have credit cards thancomparable households that did not filefor bankruptcy. If they do have cards,their lines of credit have far lower limits(by $12,000) compared with those whodid not file for bankruptcy. Moreover,bankruptcy filers pay higher interestrates (1.2 percentage points higher)than people who did not file.
5
With this theory in mind, we cannow turn to the empirical evidenceand discuss how and why studentloans outstanding and defaults haveincreased sharply and the implicationsfor the broader economy.
MORE TREND THAN CYCLERising Student Loan Balances.
 The analysis here draws on the FederalReserve Bank of New York (FRBNY)/ Equifax Consumer Credit Panel data-set, a nationally representative randomsample of anonymized credit reportsfrom Equifax, one of three majorconsumer credit reporting agencies inthe U.S., containing borrowers’ ages,amounts borrowed, and repaymenthistories for bank and departmentstore credit cards, car loans, mortgages,home equity loans, etc.
6
 Figure 1 shows the outstandingbalances for various consumer loans,credit card debt, auto loans, homeequity loans, and student loans. Notethat I omit first mortgages because,unlike the other loans discussed here,first mortgages are of much larger valueand collateralized.
7
Two observationsare worth noting. Student loans havebeen trending up since the beginningof our sample period (the first quarterof 2003), and they did not come downuntil very recently. By comparison,credit card debt and auto loans did not

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