New Approach to Student Loans

Today’s college students are saddled by debt that would have financed a small house in their parents’ college days. To help ease the burden, Congress developed a plan last month to reduce interest rates on student loans, from about 8.2% to 7.4%. The problem with the plan is that the cost would fall largely on taxpayers and would be needlessly high.

Banks and other lenders lobbied furiously against any reduction in their profit under the loan program, and the House responded with a $2.7-billion direct subsidy to lenders, making up more than half the difference. The subsidy plan was folded into the Higher Education Act and will be up for a vote in the Senate next week.

Instead of rubber-stamping the revised act, lawmakers should reduce the federal subsidy to lenders and approve a measure by Sen. Ted Kennedy (D-Mass.) that would begin extricating Congress from the whole business of setting student loan rates.

Bankers have argued that the student loans, though protected against default by a federal guarantee, cost a lot to administer because repayment can take years. But that argument is undermined by two recent analyses, one by the Treasury Department and the other by the Congressional Budget Office, showing that student loan providers have in recent years earned an average rate of return almost twice that of lenders in other banking sectors. And as Treasury Secretary Robert Rubin and Education Secretary Richard W. Riley pointed out in a May 22 letter to Senate leaders, student loan providers should earn lower than average returns because the loans are “much safer (in terms of both credit and interest rate risk) than the typical bank loan.”

The Senate needs to rethink the subsidy, which President Clinton has threatened to veto. But it should also tackle a larger problem: the lack of competition in the student loan system. Kennedy’s worthwhile pilot program would require banks to bid for the right to handle guaranteed student loans. Bidders offering the lowest interest would win; however, protections on the quality of service and loan availability to all kinds of students should be added. As a recent Congressional Research Service report put it, student loan rates are currently insulated from the “market mechanisms and market discipline” that could enhance quality and reduce costs.

It could be a revelation to see how the banks that complain bitterly about a 7.4% interest rate react when a true market is opened. Let this experiment begin.