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The Federal Student Loan Program Is Unraveling

May 9, 2024

The Biden administration recently announced its most ambitious attempt yet at student debt forgiveness. Taken together with the series of initiatives the administration has already pushed forward, the new plans promise to reduce or eliminate student debt for more than 30 million borrowers. Unfortunately, the debt-cancellation campaign fails to address the underlying problems with student lending — and such efforts at mass forgiveness only accelerate the unraveling of our federal student loan program.

President Joe Biden and his Republican critics agree that the loan program is broken. Democrats argue that the program has buried students under mounds of unmanageable debt, and Republicans believe that the program’s status as a loan program — instead of an entitlement program — has been jeopardized by Biden’s mass-forgiveness efforts.

But while this administration charges ahead with mass loan cancellation — all the while doing little to fix student loans going forward — many conservatives argue that it’s time for the government to get out of the student loan business entirely.

Privatizing federal student loans — that is, having the government pull back and allowing the private sector to lend instead — is an idea worth taking seriously. Millions of students pursue college degrees that leave them no better off financially. Students can do this because the federal government happily stumps up the money with little regard for program quality or projected earnings.

Institutions of higher learning have few incentives to improve their return on investment and every reason to prop up programs of dubious value, capturing ever more federal dollars by creating new programs and raising tuition.

A larger role for the private sector could fix this problem. When lenders use their own money to make loans, they enjoy the rewards when students repay those loans but must bear the costs when students default. They have skin in the game, meaning they will lose money if they make loans that aren’t paid back partially or in full.

To convince private lenders that their students will repay their loans, colleges will need to keep prices competitive and be much more attentive to students’ postgraduate economic outcomes — both wins from the student perspective. Thus, privatization creates an incentive for colleges to steer students toward degrees that offer sufficient value for money spent. This should come as welcome news in today’s higher education landscape, where more than one-quarter of bachelor’s degrees leave students worse off financially than when they started.

The federal government is slated to lend a trillion dollars in new student loans over the coming decade, and the Congressional Budget Office expects the government to lose around 25 cents on every dollar it lends over the next decade. Student loan privatization could therefore save taxpayers at least a quarter of a trillion dollars over a decade.

In practice, the savings will be even greater because an end to federal lending will remove future administrations’ ability to essentially buy votes by promising loan cancellation. Lawmakers could use those savings for deficit reduction, or to expand financial aid for truly needy students.

But lawmakers who want to pursue privatization must avoid several traps. They should avoid any form of federal guarantees for private student loans, as these transfer the risk of default from the lender to the taxpayer. A return to the Federal Family Education Loan (FFEL) program, for instance — when the federal government guaranteed private loans — should be discouraged. Such arrangements enable lenders to reap all the rewards but bear none of the consequences of making bad loans. That removes most of the incentive for lenders to ensure loan dollars only flow to quality education.

Scaling back federal lending alone is not enough to create a thriving private student loan market. Leaning against financial innovation, hostile regulators often threaten to block the private sector from using factors correlated with each college’s financial value — like projected earnings or program return on investment — to make lending decisions, forcing them to fall back on less relevant but grandfathered-in metrics like FICO scores.

The Consumer Financial Protection Bureau has even argued using a college’s default rate could run afoul of fair lending laws. Without legal protections for lenders who make decisions based on colleges’ outcomes, overzealous regulators can throttle the private market.

Finally, proponents of privatization should not dismiss the accessibility issues that the end of federal lending could create. Around half of four-year college students rely on federal loans to help pay for college, including many with limited family resources. Some could undoubtedly secure private loans instead, but others will be left without adequate access to credit. But instead of haphazardly expanding access by offering colleges a convoluted backdoor subsidy through federal loans that will never be paid back in full, Congress should consider using a portion of the savings from privatization to increase the Pell grant, a student aid program for low-income students. Unlike loans, Pell grants do not need to be repaid, so this would help to defray the cost of college and reduce students’ need to borrow.

American universities remain the envy of the world, but the dysfunction of the federal student loan program has broken the promise of higher education for too many students. While helping students access higher education is a laudable goal, policymakers should consider that the federal government’s 60-plus-year adventure into student lending has done more harm than good. Privatization, along with other sensible reforms, would help ensure students come out ahead when they pursue college.