Are lower interest rates the best route to a fairer, more effective student loan program? From the rhetoric heard in Congress and on the campaign trail, the answer appears to be “yes.” But both empirical evidence and economic theory show that lowering interest rates is a blunt, ineffective, and expensive tool for increasing schooling and reducing loan defaults. There are much better ways to achieve these important goals.
Let’s step back and consider why government lends to students in the first place.
Education is an investment: it creates costs in the present but delivers benefits in the future. When students are in school, expenses include tuition, school supplies, and lost earnings. Benefits after school include increased earnings, improved health, and longer life. To pay the costs of their education, students need cash.
In a business deal, a borrower might put up collateral in order to fund a potentially profitable investment. The collateral would include any capital goods used in the fledging enterprise, such as a building or machinery. Similarly, homeowners put up their home as collateral when they take out a mortgage.
While there have been occasional efforts to offer student loans securitized by human capital (e.g., MyRichUncle[i]), none has moved beyond a small niche market. This is because it is very difficult for private parties to place a lien on (or even confirm) individual earnings.
This private market failure is one reason why government plays an important role in lending for education. Governments, through the income tax system, have the unique ability to both measure and collect income.
Given that federal loans are intended to correct a capital market failure, how should they be designed? What interest rate should be charged? If providing liquidity is the only goal of the loan program, loans would be provided at an interest rate that covers the government’s cost of making the loan. Taxpayers would seek neither to make money from these loans, nor subsidize them.