The Perils of Risk-Based Student Loans

Among the few indications of a higher education policy from presumptive Republican presidential nominee Donald Trump is a proposal for “risk based” student loans managed by lenders instead of the colleges.

The concept of risk-based student loans is that students who are more likely to repay their loans would be charged lower interest rates or receive more favorable repayment terms. For college students, their selection and completion of a major would be tied to the likelihood that a student would earn a wage that was more than sufficient to repay their student loans.

For example, a high school senior who is considering a major in computer science or engineering, and checks that major off on their college application, could receive a loan at a lower interest rate than another high school senior who checks off elementary education as their intended major. The lender would make the loan on the basis that the borrower who earned the computer science or engineering degree would earn more than the prospective teacher. This presumes that high school seniors have thoroughly assessed their academic strengths and weaknesses, the colleges that best fit their abilities to address them and are set to finish a degree in their intended major on time.

That is an awful lot to expect of most college-bound high school seniors, even exceptionally bright ones. It also presumes a great deal about the advising that each potential student borrower has received from their parents, teachers, school counselors and others.

Take the risk-based student lending idea a step further. Suppose banks and public policy makers treated all freshmen and sophomores the same.

All freshmen and sophomores would be treated the same with respect to interest rates as well as interest subsidies, regardless of their intended major. The changes would come after each student borrower has decided on a major, beginning in the junior year. Juniors who are in good standing in “target” majors as decided by the Federal Government, and possibly the state government in the student’s home state. Those who are not enrolled in a target major would receive loans on less favorable terms. They might be authorized to borrow less or repay their loans at higher interest rates.

Proponents of risk-based student loans call the more favorable terms incentives to become part of a profession in demand. In a sense that’s true. A college student who is struggling in an engineering or science curriculum could be motivated to try harder in school. That presumes that s/he is headed into the vocation that is their true calling. That’s a lot to presume.

The mere granting of a degree does not automatically mean that the degree holder will have a job waiting after graduation. The most desired employers who seek computer science, engineering and “hard” science graduates will pursue those who have the strongest commitment to their major and the field. That means excellence in the classroom. These employers want to hire new employees who are less likely to struggle in the workplace. If a student found it tough to go to school, when s/he had a more flexible schedule and resources to help, then how would that student fare on the job, when deadlines are firmer, life is less flexible and help less available when everyone else has their own work to complete?

A risk-based program might get more students to complete these degree programs. But it offers no assurances that more of these graduates will excel in the field or that they will finish those degrees on time. Imagine if a student who is struggling in engineering approaches their lender, asking for a student loan for an extra semester or year because s/he fell behind in their program by failing a course or two? Doesn’t the risk of lending to that borrower go up because s/he has a more difficult time doing the work?

Then there is the consideration of the college where the student borrower is enrolled.

Imagine one school where most of the entering freshmen finish their degree on time. It likely has students who excelled in high school and want the traditional college experience, including life on campus away from home. Too many college rankings are heavily based on the “quality” of the students as they came in from high school, with their grades and test scores. The smarter they were coming in, the reasoning goes, the more likely they will come out with a degree.

Then consider a second school, one that offers the target majors, but it less selective. It might be quite inexpensive, relative to the first school, but also might be more commuter oriented. It might be least-cost alternative for many students as well as their families. However, the students who enter, are on average not as bright as the students who enter the first school. The US Department of Education also has data that students who are enrolled at this school are not only far less likely to graduate; they are also far more likely to default on their student loans.

The University of California system has several campuses that follow the first example, the most successful being UC-Berkeley, UCLA, UC-Davis, UD-Santa Barbara and UC-San Diego. The California State University system has a lot of schools like this second example and they offer degrees in many of the likely target majors desired by the Federal Government and the state government.

Now go a step further. We have a prospective community college student who is graduating with honors from a pre-engineering curriculum at Miramar College in San Diego. S/he has the opportunity to transfer to UC-San Diego or San Diego State. They both offer the target engineering major our student wants. San Diego State offers a scholarship that covers a third of the tuition, and has a base rate that is already lower than UC-San Diego charges its undergraduate engineering students.  UC-San Diego offers no money at all, only the opportunity to enter in the major. The internship support at UC-San Diego will be better. But San Diego State can help an engineering student find work that pays no less money.  They both offer student loans, though the interest rate for the loans to attend San Diego State will be higher.

The lender has already decided that San Diego State is the “lesser” school, even though that school is willing to offer that student an opportunity to pursue essentially the same education at a lower price. In effect the lender is telling that student that s/he should borrow more, and therefore take on more risk.

Risk-based lending might provide an incentive for college students to pursue a more demanding as well as a “more needed” degree program. But it does not offer assurances that industry, non-profits and government would get the best workers for those jobs. Worse, if the risk is applied to the perceived quality of a school, it could lead colleges to discount their costs further than they should and even lead colleges to shutter academic programs that are non-targeted or too difficult to support. It could also lead students to make poorer, and sometimes more expensive, college choices. Of course that would not bother The Donald. He transferred from Fordham to have the opportunity to graduate from Penn.

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