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Explainer: the US student loan problem and how we got here

How did US student loan debt get so big? Flickr/thisisbossi, CC BY-SA

The US student loan system is unique in age, size, and scope. Since 1958, the US has had some form of federally sponsored student loan system. Since inception, college and borrowing have become much more popular, and average balances of student loans have also grown. Currently the federal portfolio consists of more than $US1 trillion of debt.

What’s worse is it’s unclear just how much of that money the government is going to get back. The federal government treats student-loan debts as assets because they can’t be discharged under normal circumstances. But that assumption is starting to look at tad optimistic. Studies by the New York Federal Reserve Bank show that about a third of borrowers under 30 and in repayment are delinquent.

How did the debt get so big?

College tuition fees in the US are not strictly regulated, and the system includes public, private, and for-profit universities. This results in a wide range of tuition and fee charges.

There’s a cap on federal loans for undergraduates: $US31,000 for dependent students, and $US57,500 for independent students. These limits are larger for graduate students, and these balances can grow larger than the caps if payments are not made.

Protests at Washington Square Park. Flickr/Max Lib, CC BY

The federal loan system is designed to make sure qualified students have access to college, but also that they repay their loans to satisfy investors and protect the government.

This is a system that seems to benefit everyone, and while there have been warning calls for decades about the growth of student loan programs and perverse incentives for both students and institutions, student lending in the United States continues to grow.

Student debt is one of the only types of consumer debt where credit ratings and ability to repay are not taken into account. This has led several countries to adopt income contingent repayment plans intended to reduce the repayment burden for graduates who have a tough time in the initial job market.

These programs are a lifeline for many former students but can be a risk to the governments that hold the debt.

How are student loans managed elsewhere?

Since 1989 Australia has had a government-funded student loan program. Repayments begin once graduates reach a certain level of income so they only start paying down their debt after they have entered the working world, this is known as an income-contingent loan.

This system does not involve commercial interest; instead loans are indexed to inflation. There is no repayment for a current salary of less than about US$46,500, and a maximum of 8% of total income is collected for loan repayment. There is currently about $AU23 billion of student loans owed to the government (about $US20 billion).

Australia is planning a move to bond-rate interest for current and future student loan balances beginning in 2016, more accurately reflecting the cost of borrowing.

According to recent research, about 20% of loan dollars lent today will not be recovered, and this amount may rise depending on the result of proposed reforms or if higher interest rates make it more difficult to pay down principal.

Hello. My debt is… Flickr/Max Lib, CC BY

The income contingent loan system in England is younger but is growing more quickly, as England responds to budgetary issues in higher education by raising tuition.

England currently has about £54.4 billion (about $US86.5B) in outstanding obligations according to a study commissioned by the parliament. Its loan program has only been in place since the early 1990s.

The first tuition charges did not occur until 1998. Tuition caps, which were originally £1000 per year in 1998 rose to £3000 in 2004 and £9000 in 2010, a rate since adopted by most institutions.

All graduates are enrolled in an income contingent program. The English system takes up to 9% of income above an income level of about US$33,000 for 30 years. A report from the Business, Innovation and Skills Committee of Parliament estimates that lending losses may be as high as 45%.

Should we expand income contingent loans?

Although some income contingent programs have been available since 1994 in the United States, the program that is known today as income-based repayment was enacted in 2007 (followed shortly by Pay As You Earn and 2014 IBR for newer graduates). In comparison to Australia and England, the United States has a low income-based repayment adoption rate. Students must qualify for income-based repayment plans, and many do not even attempt the process.

For the most recently tracked cohort that began student loan repayment in 2011 – almost all of whom would be eligible for income-based repayment plans if they were to enroll – there is already a 13.7% default rate three years after finishing school. Currently, default is defined as missing payments for more than 270 days.

Overall, the US student lending portfolio is much larger than those of peer nations, and current policy changes largely advocate for the increased adoption of income-based programs for current and former students.

In contrast to the Australian approach of raising interest rates to offset losses, the American program continues to become more forgiving to graduates entering repayment, as income based repayment programs have fallen from 20% of income in the 1990s to as low as 10% of income today. There are also proposals to reduce interest rates on existing loans.

According to the Congressional Budget Office, student loans will return a profit of about US$135 billion over the next ten years (using FCRA estimates). However, when the same program is analyzed using fair value accounting–which considers additional risk and market interest rates–it projects a loss of up to US$88 billion over the next ten years (and this is too soon to account for many balances that could be forgiven). Considering the extended repayment timelines of many loans, ten years may not be long enough to consider the total costs of these programs. Student loans are not the only type of debt projected to make money under FCRA and lose money under fair value accounting. Federal Housing Administration programs are still bigger than federal student loans, but the student loan portfolio has grown from 20% of the size of FHA programs in 1992 to 60% of the size of FHA programs in 2011. Student loans are considered more profitable than housing programs under FCRA, and projected to lose more than housing programs under fair value.

In all three countries, income contingent repayment programs are popular for students and are likely to stay, despite the costs to government of incomplete repayment.

If these programs result in large costs to their respective governments, it may make sense to begin to return to pre-loan public education systems and have educational costs financed directly by governments, such as the current model in Germany.

While student loan costs can currently be borne by governments, these programs are likely to have growing costs as adoption increases and tuition growth outpaces inflation.

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