Subsidized Loans Drive College Tuition, Student Debt to Record Levels

July 17, 2013

A proposal to restore the lower interest rate of 3.4 percent on student loans from its recently increased 6.8 percent for another year failed in the Senate recently. The common response to this vote is that it is a tragedy. It isn't, says Veronique de Rugy, a senior research fellow of the Mercatus Center.

  • First, even at the 6.8 percent rate, students are still benefiting from a significant subsidy; the rate on similar loans that students obtain in the private market is about 12 percent.
  • Second, extending the lower rate would be reckless since it would continue to artificially inflate the student loan bubble. Data from the Federal Reserve Bank of New York shows that over the past decade, student loan debt has increased by 281 percent, from about $260 billion in the first quarter of 2004 to $990 billion in the first quarter of 2013 and is now higher than the country's collective credit card debt.

Thus begins a classic upward price spiral caused by government intervention: Subsidies raise prices, leading to higher subsidies, which raise prices even more. Yet this higher education bubble, like the housing bubble, will eventually pop. Meanwhile, large numbers of students will graduate with more debt than they would have in an unsubsidized market.

What's the harm in that?

  • First, in the current slow economic growth environment, many recently graduated students have a hard time finding a job but they still have to repay their loans. As a result, the overall default rate for those receiving a federal student loan is 23 percent. To put this in perspective, at the peak of the housing crisis in May 2009, first-mortgage default rates reached 5.7 percent.
  • Second, according to researchers at the New York Fed, the surge in student-loan debt has been turning investment in education for many borrowers from a good investment to a bad one. The rise in student debt followed by a surge in defaults has damaged the credit scores of student borrowers relative to non-borrowers, a stigma that may pursue them for a while.
  • Third, and more important, taxpayers face two equally bad outcomes: They are subsidizing millions of dollars in interest for student loans that they shouldn't have to shoulder, and they likely will pick up the tab for underpaid student loans. In fact, according the Congressional Budget Office, the losses shouldered by taxpayers due to student loans will amount to $95 billion over the next 10 years.

Source: Veronique de Rugy, "Subsidized Loans Drive College Tuition, Student Debt to Record Levels," Washington Examiner, July 11, 2013.

 

Browse more articles on Education Issues