There is now $1.2 trillion of student loan debt in America, and that number just continues growing. The Class of 2014 was the most indebted class ever, with average debt of $33,000. Over the next few weeks, the Class of 2015 will likely have even more debt.
There are many reasons we are drowning in debt. Budget cuts for state universities have resulted in dramatically higher tuition. Private universities have engaged in a destructive spending war, driving up the cost of tuition much more than inflation. If you have visited a private university in the last decade, you would likely be greeted by cranes and construction as universities begin to resemble resorts. In addition to state-of-the-art rock climbing walls and beautiful residential facilities being constructed, the number of academic administrators has doubled in the last 25 years. Students want the best education. For some reason, many students equate the best education with the most expensive education. So colleges are meeting that demand by building, growing, expanding and charging as much as they can. And the federal government is funding that increasing cost with ever-increasing student loan debt.
Most high school students don’t receive financial literacy education in high school. And very few students complete a cost benefit analysis before making their college decision. That is unfortunate, because there is an abundance of publicly available data. If you want to become a doctor, engineer, teacher or social worker you can make a good estimate of your earning potential. Students should be thinking about their lifetime earning potential when deciding how much debt they are willing to take. And colleges need to start feeling the pressure. Higher costs don’t mean higher quality. And just because the federal government is willing to lend you the money, doesn’t mean you should spend it.
We are already starting to see very clear warning signs that the system is broken. I will deal with the three biggest alerts.
1. Defaults Are Soaring
Student loan defaults are soaring. 11.3 percent of student loans are now 90 days or more delinquent. And that number will only continue to increase, as more students have to start making payments. If you have $30,000 of student loan debt and have an income of $30,000 it will be very difficult to make the payments on time.
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If the federal government had to build loan loss reserves in the same way as private banks, the student loan portfolio would not look nearly as profitable as it does. I have no doubt that this is a credit bubble waiting to explode, and that taxpayers will feel the full brunt of the pain over the next 10 years.
But as bad as this is for taxpayers in general, it is worse for the graduates with the debt. Student loan debt will prevent them from buying cars and homes or saving for retirement. We should just call a student loan what it is: a new form of taxation. The interest on federal student loan debt goes to the federal government. And it is a regressive form of taxation: the less money you make, the heavier the burden. If that isn’t a tax, what is?
2. Messy Political Responses Are Being Created
With so many students defaulting on student loan debt, political solutions are inevitable. In the last few years, we have seen some programs introduced that will offer significant relief to borrowers with federal student loan debt. There are now income-based repayment programs that will cap your monthly payment to 10 to 15 percent of your income. After 20 to 25 years, the federal government could even forgive the remaining principal balance.
This is a great opportunity for borrowers with federal student loan debt to take back their lives. And I encourage them to take advantage of this program.
But this policy also has long-term dangers. Colleges and universities will have no incentive to cut costs. They will continue to increase tuition and encourage students to take out debt. And if I were a high school student completing a cost-benefit analysis, I wouldn’t feel the pressure of choosing a less expensive school. Why should I? If I take out federal loans, I won’t have to pay it all back. I will only have to pay 10 percent of my monthly income, and the remaining balance is forgiven.
The cost to the taxpayer could be significant. The biggest beneficiaries will be the universities, who will not feel the pressure of finding more cost-effective ways to provide an education.
3. The Best Borrowers Will Leave the Federal Program
The private sector is starting to get active. Start-ups, credit unions and even some commercial banks are recognizing that the interest rates on student loan debt are just too high. So they have created programs that enable people with the best jobs, best income and best credit scores to refinance. At MagnifyMoney (my website), we have found 19 (and counting) lenders willing to refinance student loan debt, with interest rates starting as low as 1.9 percent.
This is a great deal for borrowers, and if you qualify you should definitely consider refinancing. The lifetime savings can be dramatic. Just be careful before refinancing a federal student loan with a private lender, because you will be giving up the ability to take advantage of income-based repayment programs. If you have a private student loan, it is an obvious solution.
But this is yet another risk for taxpayers. The private sector will be very good at identifying the best credit risk profiles and offering them much better interest rates than the government. That means the government portfolio of loans will be left with the riskiest borrowers. Default rates on the federal portfolio will increase, because the performing loans will move to the private sector. Revenue will plunge.
The Perfect Storm
Student loan debt continues to grow, and a credit bubble is forming. Defaults will continue to increase. Politically motivated programs will continue to offer more forgiveness. Private lenders will continue to steal the best credit risk profiles. And, at the end, taxpayers will be forced to pay for the mess, but only after graduates find themselves drowning in debt.
This seems like a very complicated and dangerous way to fund college education. Colleges need to feel competitive cost pressure, like any other private organization. High school students need to do the math before they make a college choice, and recognize that their dream school may not be worth the money. And our lawmakers need to re-think how the entire system is funded, and recognize that every bit of incremental meddling create even more unintended consequences.
Nick Clements is the co-founder of MagnifyMoney, a price comparison and financial education website. He spent his career in banking, and used to run the largest consumer credit card business in England. You can follow him on Twitter @npclements.