President Biden’s student loan forgiveness program and expansion of income-based repayment plans have shredded any pretense that federal student loans are a financially viable program. Loans were already losing 10 cents on the dollar, on average, before the president’s actions added $1 trillion to their cost. In the future, many students will pay back half of what they borrowed or less. All this will encourage schools to raise prices to capture the new subsidies.
The irony of loan forgiveness is the implicit admission of its funders of higher education: it’s not always worth it. If the college offered a reliable financial return, there would be no need for these new grants; borrowers could repay their loans with interest. But in reality, many students don’t graduate, while others find their degrees to be of little value in the job market. When factoring in tuition, time out of the workforce, and risk of non-completion, 28% of bachelor’s degrees do not justify the expense.
For the sake of students and taxpayers, Congress must urgently fix federal loans going forward. It should ensure that loans are only given to programs that have a proven track record of graduating their students and providing them with the skills they need to land good jobs and pay off their debts. Otherwise, in a few years, we’ll be back to where we started: with more unpaid student loans and more pleas for forgiveness.
Holding colleges accountable for unpaid student loans
An effective accountability system will have several elements. First, the federal government should require colleges to share the risk of nonpayment of student loans. The economic value of higher education is closely linked to the rate at which students repay their loans, for the simple reason that student loans are more manageable when tuition fees are lower and income after graduation degree are higher. Sharing the risk of student loans incentivizes schools to keep prices low and revenues up.
Specifically, when students are not on track to fully repay their loans, colleges should pay a penalty equal to a percentage of the outstanding loan balance. Penalty ratings should be progressively higher when loan performance is worse.
If borrowers make progress on their loans but not enough to repay them in full, the college should pay a small penalty, enough to incentivize improvement but not financially ruinous.
But when borrowers fail to even cover the interest on their loans, their school would have to pay a much higher penalty, high enough to make college management question whether continuing to draw on federal student loans is worth it. Ideally, colleges will voluntarily withdraw their lower-quality programs from federal loans and redirect their resources to programs that produce much better student outcomes.
Require colleges to guarantee risk-sharing payments
One of the challenges of student loan risk sharing is the time lag between when the government disburses loans and when it measures loan repayment results. Ideally, risk sharing would encourage colleges to work on improving outcomes before the first penalty is imposed, but the long delay weakens this incentive. Therefore, colleges wishing to participate in federal loans should provide financial assurance that risk-sharing penalties will in fact be paid.
Schools could satisfy this financial guarantee in a number of ways. First, the Department of Education could withhold some student loan funding until results are achieved. If a college owes risk-sharing penalties, these will come directly from the undisbursed portion of the loan. Essentially, colleges will not be fully paid until they produce the results taxpayers expect for their investment in higher education.
Some schools will object that they need all of their student loan funding to provide a high quality education. If a college is satisfied that its programs will not incur risk-sharing penalties, it should convince a third-party financial institution of this fact. If a third party agrees to guarantee any risk-sharing penalties the college may incur in the future, then the school may receive full disbursement of the loan in advance. The third-party guarantee will protect taxpayers’ investment and provide additional market discipline to support strong college outcomes.
Reward schools that offer high quality at low cost
The government shouldn’t just punish poor performance in colleges; it should also reward schools that offer their students upward mobility at affordable prices. To that end, policymakers should use funds raised through risk-sharing penalties to increase federal Pell Grants for students in programs that charge modest tuition and provide a reliable ticket to the middle class.
The federal government could selectively increase the maximum Pell Grant for programs where the ratio of median graduate earnings to tuition is high. This will encourage schools to enroll more students in high-value fields of study such as nursing and computer science. Additionally, the phasing out of additional Pell Grant funding for institutions that charge high tuition will discourage schools from raising prices to capture the additional aid, as often happens now.
The Pell Grant program, which provides financial aid to low- and middle-income students, is an ideal vehicle to provide this results-based funding. Institutions will only receive additional Pell Grant funding if they enroll more Pell Grant-eligible students, namely low-income students.
Advance on responsibility
Congress has a chance to reform the student loan program before the searing cancellation knocks it off the tax track. The best way forward is to implement student loan risk sharing, require colleges to guarantee payment of penalties, and use revenue to increase Pell Grants for high-performing programs. This will protect students from poor performance and reward colleges that serve their students well. But time is running out: policymakers will need to act quickly to stop the next student loan crisis before it happens.