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September 04, 2009 2:32 PM No, the Government Shouldn’t Emulate Private Student Loan Companies

By Pedro de la Torre III

After a pretty good Wall Street Journal article on the huge increase in the amount of federal student loans disbursed for the 2008-09 academic year, Daniel Indiviglio argued at The Atlantic that the federal government should be more like private loan companies when it comes to deciding how much particular students should be allowed to borrow. Felix Salmon of Reuters made a similar argument. But a quick look at how private student loans work quickly reveals this to be a bad idea.

As commenters to Indiviglio’s post pointed out, the federal government already has limits on the amount students (and their parents) can borrow. While these limits still represent a heavy burden for students just starting their out their careers (especially if they want to be teachers, social workers, and other sorts of do-gooders), borrowers would be in a much better position if they stuck to these limits.

Private student loan mongers, on the other hand, are often willing to make enormous loans to students, often with high and variable interest rates and few borrower protections, and sometimes with the knowledge that many will be unable to repay the loan. They also tend to specialize in lending to students at for-profit colleges, many of questionable quality and character, and some of which rip off their students.

Why would they do this? One reason is federal protection. While these loans do not come with federal guarantees against default like loans made through the (hopefully moribund) Federal Family Education Loan Program (FFELP), borrowers will find the loans virtually impossible to discharge in bankruptcy.

Strict credit standards in federal programs would only serve to drive students or their parents to more risky loans. The Student Lending Analytics Blog recently found that rejection rates were much lower for PLUS loans (federal parent and graduate student loans) that the Education Department made directly to students than they were for those made through FFELP. When it comes to PLUS loans, minimum standards are dictated by government policy, but lenders that participate are free to be more discriminating.

Unfortunately, the result seems to be that lenders utilize their near-monopolies at many schools, and the lack of comparative shopping on the part of student loan borrowers, to point them toward risky and expensive private loans instead.

Finally, Salmon’s post takes the following quote from the Wall Street Journal piece out of context:

The total borrowing limit for dependent undergraduates who take out federal Stafford loans—the most popular federal aid program—grew to $31,000 this past school year from $23,000. Raised limits in federal loans may have siphoned some borrowing away from riskier—and costlier—private loans, which are now harder to get due to the retrenchment of that business. The move away from these risky loans may be one bright spot in an otherwise frenzied student credit environment, [financial aid expert Mark] Kantrowitz says.

From this, Salmon infers that “this is good news: students are moving from expensive private loans to cheaper federal loans.” In fact, while increased federal loan limits may have slowed down the growth of private student loans, the percentages of both students taking out private loans and private loan borrowers who do not exhaust their eligibility for federal financial aid are actually growing.

Pedro de la Torre III is the Advocacy Senior Associate for Campus Progress. The views expressed here are his own.