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Thursday, April 28, 2016

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Cascade: No. 84, Winter 2014

Student Loans: A Primer*

On average, higher education is a great investment: The average person with a four-year degree earns substantially more than the average high school graduate,1 and the cost of that degree is well below the financial benefits that are derived.2 However, borrowing to pay for education has risen dramatically in recent years, with outstanding student debt recently passing $1 trillion, which is almost four times the debt incurred in 2004.3 Today, an increasingly large number of borrowers are unable to make their student loan payments,4 which raises concerns about what this means for individuals and for the economy as a whole.

How Do Student Loans Work?

Simply stated, student loans are a specific set of financial products that allow individuals to borrow money that will be used to pay for education. Because widespread access to higher education has been a long-standing policy goal in the United States, these loans have historically had low interest rates and have been widely available, with very little in the way of underwriting standards that are often used for other forms of credit, such as mortgages and credit cards. Today, an overwhelming majority of such loans are originated by the federal government;5 however, until 2010, many loans were originated by private lenders and guaranteed by the federal government. Because student loans usually have a 10-year term, many such private loans, which typically have higher interest rates and less flexibility in repayment terms, are still outstanding today. In addition to these problems, student loans can be difficult to refinance and almost impossible to discharge, even in bankruptcy. Although student loans are typically associated with the young, and the problem is often highlighted in relation to recent college graduates struggling in a weak economy, only about 40 percent of student loan borrowers are under the age of 30.6

Why Are Student Loans Receiving So Much Attention?

Since the beginning of 2004, outstanding student loan debt almost quadrupled, from $0.26 trillion to $1.03 trillion,7 which has led to speculation about a student loan bubble reminiscent of that seen in housing at the end of the last decade. The outstanding debt is increasing at least in part because of rising college costs, as shown in the figure. Between the 1990–91 and 2011–12 academic years, the average price of a year of college education had risen by more than $8,000 in constant 2012 dollars. Although this has been partially offset by increases in grant aid, much of the cost increase has been absorbed by student loans.

However, college remains a good investment, as long as students can pay off their loans. The challenge with student loans, therefore, is not in borrowing but in repayment. Students who start college but drop out are at particularly high risk because they incur costs without the full payoff of receiving a degree. Similarly, students who spend additional time completing their degrees are disadvantaged because they incur additional costs but with no greater future payoff than students who graduate on time. More students fall into these groups than many people realize: In 2011, the six-year graduation rate for full-time first-time undergraduate students seeking a four-year degree was just 59 percent.8

Financing the Average Cost for One Year of Undergraduate Education (Constant 2012 Dollars)

The chart is adapted from work by the Hamilton Project.a Cost data include tuition, fees, and room and board.b Grant aid includes federal grants, education tax benefits, Federal Work–Study income, state grants, institutional grants, and private and employer grants. Student loans include federal and nonfederal loans.c Out-of-pocket expenses are total costs minus grant aid minus student loans.d

What Are the Implications of Inability to Repay Student Loan Debt?

For borrowers who fall behind on their loan payments, the consequences can be serious. Failure to make the required payments will damage a borrower’s credit score and may limit his or her access to other forms of credit, such as mortgages or car loans. Even if borrowers stay current on their loans, the money used to make loan payments is not available for other uses, which limits their spending. For example, borrowers with student debt may not have the ability to pursue their desired career, start a business, or retire at an earlier age. Additionally, it is not always just the student who is affected. A student’s family may take on loans to pay for the student’s education (e.g., through the Federal PLUS Loan program9).

Are There Any Potential Solutions to These Problems?

Because of rising student loan delinquency rates, several potential strategies, including income-based repayment, longer repayment periods, loan forgiveness in exchange for working in certain key fields, and automatically withholding funds from paychecks, have been proposed. Some of these strategies have been introduced for certain federal loans, but efforts have been somewhat undermined by confusion over which loans are eligible. In addition, private lenders have been reluctant to make concessions.

Finally, entirely new products in education and finance have started to appear that may change the student loan landscape in the long term. Massive online open courses have proliferated in recent years, offering free or very low-cost college courses to anyone with an Internet connection. Also, new direct lending and investment models of financing that connect individual investors with students have been introduced by nontraditional financing companies such as CommonBond, SoFi, and Pave. CommonBond, founded by students at the University of Pennsylvania’s Wharton School, and SoFi attract investors from a school’s alumni base to lend money to the school’s current students at a lower interest rate than the market provides, while Pave allows an investor to pay for a student’s education in exchange for a portion of his income for a set period of time thereafter.


College remains a great investment when financed appropriately, but an increasing number of student loan borrowers are struggling with their debts. This has negative implications for the borrowers and for the wider economy, and potential solutions have had a limited impact to date.

  • * The views expressed here are those of the author and do not necessarily represent the views of the Federal Reserve Bank of Philadelphia or the Federal Reserve System.
  • 1 U.S. Department of Labor, Bureau of Labor Statistics, “Earnings and Unemployment Rates by Educational Attainment,” External Link 2013.
  • 2 Anthony P. Carnevale, Stephen J. Rose, and Ban Cheah, “The College Payoff: Education, Occupations, Lifetime Earnings,” External Link Georgetown University Center on Education and the Workforce, 2011.
  • 3 Federal Reserve Bank of New York, “Household Debt and Credit Report,” External Link 2013.
  • 4 In the third quarter of 2013, 11.8 percent of outstanding student loan balances were delinquent, as compared with 6.3 percent in the first quarter of 2004. See Federal Reserve Bank of New York, “Quarterly Report on Household Debt and Credit,” External Link 2013.
  • 5 In the 2012–13 academic year, 92 percent of all student loan debt originated came from the federal government. See College Board, “Trends in Student Aid 2013.” External Link
  • 6 Meta Brown, Andrew Haughwout, Donghoon Lee, et al., “Grading Student Loans,” External Link Federal Reserve Bank of New York Liberty Street Economics, 2012.
  • 7 Federal Reserve Bank of New York, “Household Debt and Credit Report,” External Link 2013.
  • 8 U.S. Department of Education, National Center for Education Statistics, “Fast Facts: Graduation Rates,” External Link 2013.
  • 9 The Federal PLUS Loan program allows the parents of undergraduate students to cover any gap between the financing their child has available and the full cost of their child’s program.