The Particular Dangers of School Loans
Are student loans, in fact, particularly dangerous? Let’s start off by acknowledging that all loans are in some way dangerous. The Bible stops short of calling debt sin but discourages their use vehemently. It variously refers to loans as curses, stupidity, and snares among other things. “The borrower is slave to the lender” still rings true in our free society, with “I owe, I owe, it’s off to work I go” being the driving force behind disagreeable careers everywhere. While financial geeks can dither about the differences between “good debt” and “bad debt,” even in instances of so-called good debt such as mortgages and student loans the borrower should heed these warnings and proceed with utmost caution. Especially when lenders structure their loans to set the borrower up for failure.
Take what occurred in 2008, for example. The housing bubble had finally popped and threatened to take the whole country down with it. It all started years earlier when the sorts of precautions and safeguards normally tied to federally-standardized housing loans had been overly loosened or outright disregarded for some time. This lack of mortgage system oversight caught up to us when the real estate market began to cool down and we discovered that too many loans had been written under ridiculous assumptions. The entire financial system shuddered and large institutions shuttered. American leadership panicked, doing whatever sort of stop-gap measures it could think of to ease the pain until things could straighten out. The citizenry suffered mightily for it in the form of foreclosures, job losses, inflationary pressures, a stagnant economy, municipal defaults, urban blight, and other side effects still largely felt today.
What does this have to do with students in 2014? I think this history serves as a precautionary tale as to what can happen when systematic loan standards fail to prevent people from taking on debt prudently. To some degree the world of mortgage loans has returned to some sense of normalcy with many more checks and balances in place than existed before the crisis. However, when one looks at not only the size (well over $1 trillion and counting) of our student loan debt but also the structure, one notes an uncannily familiar lack of constraint baked in. A student must be cognizant that the loan system itself will not prevent unduly large or otherwise nonsensical borrowing. In fact, the system almost encourages negligence and incentivizes bad behavior.
To see what I mean let’s compare prudent lending, as illustrated by a mortgage contract, with the status of today’s student loans (with particular emphasis on the subsidized variety) by asking three important questions about the nature of the loan:
Who Qualifies for the Loan?
Under a mortgage agreement, borrowers must pay a down payment (the more substantial the better the terms), must show that they have a good credit history of paying bills on time, and take home a sufficient and stable income. This protects both parties from agreeing to something that would result in undue hardships and non-payment. Incidentally, largely because of these requirements, the average first-time home buyer is now around the age of 34.
Student loans, on the other hand, work in almost the exact opposite way. The bulk of them go to newly minted adults with no previous experience handling large sums of money and who earn little, if any, income. In fact, the financial aid system assures that best types of loans purposefully go to students with the least amount of assets/income.
What Determines the Maximum Loan Amount?
The typical home loan maxes out at the value of the house being bought, with many programs requiring a certain amount of equity from the start in the form of down payment. In other words, I cannot borrow more than my home is worth and sometimes less. This is good for the lender in that if the borrower doesn’t pay they have some assurance of recovering the principal and for the borrower in that it limits our ability to dig a bigger hole than we can get out of. In the worst case scenario either party can sell the home to settle the balance.
The typical college note, in contrast, has an arbitrary annual maximum not at all predicated on the economic value of the education. First year students can get a Stafford loan of $5500 whether they plan to major in chemical engineering or Latin, whether they go to a quality institution or enroll in one of those schlock schools advertised on daytime TV. Furthermore, no safeguards are in place if the student drops out and foregoes the benefit of a degree altogether. If you end up being one of the 40% or so of students that does just this, you can’t exactly sell your transcript to the next guy down the line to recoup your costs. In fact, it’s one of a rare breed of debt that cannot be discharged in bankruptcy and collectors can go nuts on those who don’t pay up. Get in over your head and there are no do-overs.
Where do the Funds Go?
When taking out a home loan the funds go to… a home. The lender makes sure of this by issuing the loan amount via a check to the title company who oversees the payment of the appropriate parties and gives you a clean title to your home. The borrowers then move in and begin making payments within a month.
Student loans are issued in such a way that a student can use them indiscriminately. Whether the student then applies the funds to the tuition bill or Star Wars memorabilia matters not to the lender. As you might guess this causes all sorts of unnecessary temptation and largely accounts for the liquor stores, tattoo parlors, and restaurants that surround college campuses. There’s no telling what portion of student debt literally gets flushed down the toilet on a Friday night.
Add to this the fact that many college loans don’t come due until some time after graduation and you can see the inherent incentives stack up in the favor of stupid.
We’ll discuss the nature of college loans in further detail down the road as well as how to determine the “proper” type and amount. In the meantime don’t get lulled into subconsciously thinking that the system is created with your best interests in mind. You are on your own to ensure you don’t end up grappling with “good debt” gone bad. Be careful out there.