Trouble Ahead for Student Loans?

By Ergungor, O. Emre; Hathaway, Ian | Economic Commentary (Cleveland), May 2008 | Go to article overview
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Trouble Ahead for Student Loans?

Ergungor, O. Emre, Hathaway, Ian, Economic Commentary (Cleveland)

The market for student loans may differ in some respects from other financial markets, but private lenders are the primary source of funds. As in other markets, the incentive to lend those funds comes from the ability to make a profit. But recent turmoil in financial markets is affecting all of the factors that contribute to the profitability of student loans, leading to speculation that the availability of such loans will fall.

Spring is a stressful time for college-bound high school seniors and their parents. Those who receive the thick envelope from colleges do not always have a thick wallet to pay their way through college. Thus they join the late-spring ritual of applying for student loans. The reliance on student loans to pay tuition and other expenses is what makes the. student loan industry an integral part of our higher education system. For many students, getting approved for a loan is just as important as getting accepted into a good school.

Unfortunately, the turmoil that has shaken up our financial markets since 2007 is arousing some concern that fewer student loans will be available for the 2008-2009 academic year or that interest rates will climb. In testimony before the U.S. Senate Committee on Banking, Housing, and Urban Affairs (April 15, 2008), Mark Kantrowitz, publisher of the financial aid website, FinAid, estimated that 57 lenders have suspended participation in the federal student loan program, and 19 have suspended private student loan programs. These lenders represent about 13 percent of fiscal-year 2006 federally insured private loan volume, and 67 percent of fiscal-year 2006 consolidation loan volume.

Concerns about loan availability have brought the onceobscure student loan market to the front pages of financial newspapers. Knowing how the market is structured provides some insight into how it is being affected by current financial conditions. A number of trends are working to decrease the profit that private lenders, who supply most of the funds to the market, can make.

Nuts and Bolts of the Student Loan Market

The student loan industry is a significant source of funding for college students. In recent years, annual loan originations have been in the $70 billion-$80 billion range, which is more than half of U.S. households' annual spending on higher education ($134 billion in 2006) (see figure 1). In parallel with rapidly rising college costs, the industry has seen an average annual growth rate of 10 percent between the 1995-96 and 2006-07 school years.

There are four major types of higher-education loans: those made through federal programs to students, those made through federal programs to parents, private loans, and consolidated loans. State loans are also available, but they comprise a negligible portion of the market.

Stafford and Ferions loans are the two types of federal loan programs available to students. Perkins loans are funded by the U.S. Department of Education with the school acting as the lender (doing the paperwork), and Stafford loans are originated either by private lenders using private funding sources or directly by the U.S. Department of Education using federal sources. Perkins loans and both types of Stafford loans provide a low and fixed interest rate to students up to a borrowing limit. All are insured by the federal government against default. The government also has to provide a significant subsidy to private lenders in the federal student loan program, in order to make it an attractive business proposition.

PLUS loans are offered through a federal program to the parents of undergraduates and directly to graduate students. They can be used to cover the difference between full college costs and subsidized student loan borrowing limits. Just like Stafford loans, PLUS loans can either be made with private or government funding sources. However, unlike Stafford loans, the interest rate is not subsidized while the student is in school.

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Trouble Ahead for Student Loans?


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