Is There a Student Loan Bubble?

At the end of 2018, outstanding student loan debt stood at $1.57 trillion according to the Federal Reserve, up from $1.0 trillion in 2012. Projections put the amount at $2.0 trillion by 2024. Such a large amount of debt raises questions as to whether there is a student loan bubble.

Student loan debt surpassed credit card debt for the first time in 2010 and auto loan debt in 2011. It has continued to exceed credit card and auto loan debt ever since. Only home mortgage obligations are higher.

Almost 45 million Americans have outstanding federal and private student loan debt.

Some argue that student loan debt has reached crisis proportions and fear that the student loan debt crisis may be coming home to roost. College tuition has nearly tripled over the last 50 years. College costs continue to climb, fueling the growing student loan market with few signs of a slow-down. While unemployment for college graduates is at record lows, wages have stagnated for new entrants to the job market.

This has made it difficult for some college graduates to meet their debt obligations, accrued in the first place because of the promise that a degree would offer entry into higher-paying positions. Default rates on student loans are high, particularly for college dropouts and for students graduating from two-year and for-profit colleges.

In the wake of the subprime mortgage crisis of 2008 and the resultant recession, there is concern among some financial pundits that the student loan market may be the next to collapse. Like the mortgages that were at the root of the earlier crisis, they believe that a college education may have been overvalued in respect to the amount of money used to fund it, in this case student loans.

Whether or not the effects of the student loan debt crisis and increasing rates of default ultimately cause a student loan bubble to pop, their effects are likely to have insidious and lasting effects on the economy.

Millennial Finances

As of early 2019, the national unemployment rate stood at 4% according to the Department of Labor, having peaked at 10% during the recession. The unemployment rate for college graduates is even lower, standing at 2.4% for Bachelor’s degree recipients.

This would seem to bode well for the millennial generation and their successors. However, the enormous debt burden that many carry with them out into the world after their college years has put a major crimp in their financial lives.

Graduates from the class of 2016 held an average of $29,669 in student loan debt, according to the most recent data from the National Postsecondary Student Aid Study (NPSAS). This is triple what it was in the early 1990s. Some of this is traceable to the 2008 financial collapse. Because college parents are less able to borrow against their homes due to decreases in equity and stricter lender credit criteria, their students are forced to rely on educational loans.

The likelihood that the college education paid for by these loans will be sufficient to repay the debt without significant financial compromise has also decreased. Though college education does allow students access to higher-paying jobs, wages have been stagnant for decades. An analysis by the Economic Policy Institute shows a mere 9% increase in average wages over three decades between the early 1970s and early 2010s. Inflation rates over that period have been higher.

So have the increases in student debt. In 1990, college students graduated with debt amounting to some 28.6% of their annual earning. A decade and half later, students left school with debt amounting to a staggering 78.6% of their earnings.

Borrowers can afford to repay their student loans in ten years or less when total student loan debt at graduation is less than the borrower’s annual income. Even though the average debt-to-income ratio is still less than 100%, increases in the debt-to-income ratio are a sign of increasing financial pressure on college graduates.

This unfavorable ratio between earning potential and debt has had consequences for recent graduates — and perhaps also for the economy.

Among the most concerning has been the delay in homeownership for many Millennials. A 2019 Federal Reserve report estimated that student loan debt accounted for about 20% of the decline in home ownership among young adults, a two percentage point decrease in the home ownership rate. Declining home ownership has additional effects: those who don’t own homes don’t spend on home maintenance, utilities, and repairs or amenities such as furniture.

Student debtors are also less likely to make other large purchases, such as vehicles, and are less likely to heavily use credit cards. Vacations and other luxury spending have also fallen. Retirement saving is taking a hit as well.

A 2016 report from the Small Business Administration noted that the millennial generation was also far less likely to engage in entrepreneurship, instead preferring the stability of working for someone else.

Cumulative student loan default rates, which are rising, create additional financial hurdles for borrowers who are unable to meet their debt obligations. Aside from the fact that student loan borrowers cannot discharge their student loan debt in bankruptcy except in rare cases, the effect of delinquency or default on their credit scores has multiple deleterious downstream effects.

Graduates with bad credit often cannot enter the credit market and are thus prevented from making large purchases. Low credit scores and a weak credit history can even affect employment. And whatever the case, the money will ultimately come due, along with interest and collection fees. Defaulters may thus have their wages garnished or income tax refunds offset as well.

The State of Default

In the fourth quarter of 2018, 11.4% of student debt was 90 days or more delinquent or in full default according to the New York Federal Reserve. Data released by the U.S. Department of Education in 2018 reports that cohort default rates, a short-term default rate metric, were at 10.8%. This is the lowest cohort default rate in nearly a decade. It has nearly doubled since the early 2000s. More than 9 million borrowers are in default on a federal student loan. About 1 million borrowers entered default in 2018 alone.

A Brookings Institute report based on U.S. Department of Education data suggests that long-term default rates may be as high as 40% by 2023. The budget lifetime default rate, which is based on the dollars in default, is half that estimate.

Borrowers who default on federal student loans face draconian collection measures.

After 270 days of delinquency, their debt is transferred to the Debt Management Collections System. The borrower is then given 60 days to work out a payment plan. If they do not do so, collections are transferred to a contracted student loan debt collector. The federal government can offset federal income tax refunds, garnish wages, and even offset Social Security benefit payments in order to collect.

Is There a Student Loan Problem, or Something Else?

There isn’t a student loan problem so much as a college completion problem.

Students who drop out of college are four times more likely to default on their student loans than students who graduate. College dropouts account for about two-thirds of defaulters.

They have the debt, but not the degree than can help them repay the debt.

Another factor driving the rise in defaults has been the increase in attendance at for-profit colleges and community colleges, often by low-income, minority and non-traditional students. Dropout rates are high, in part because of money problems and conflicts between school, work and home.

Students who work a full-time job while enrolled in college are half as likely to graduate within six years as compared with students who work 12 hours or less a week.

The Brookings Institute found that default rates were nearly four times higher among those attending for-profit institutions versus those attending public community colleges.

 The Brookings Institute also found that black Bachelor’s degree recipients default at a rate five times that of white Bachelor’s degree recipients. This has been attributed to lower family support due to income disparities, lower pay for black graduates entering the job market, and differing career choices.

Is There a Bubble? And Will It Burst?

The data on student loan debt and defaults are certainly alarming. And, at least by some definitions, these conditions do indeed constitute a bubble on the verge of collapse.

Government grants are failing to keep pace with increases in college costs on a per-student, inflation-adjusted basis. This shifts the burden of paying for college from the federal and state governments to families. But, family income has been flat since the late 1990s, so families do not have more resources to cover college costs.

Families respond to the increased financial pressure in two characteristic ways:

• There is a shift in enrollment patterns from higher-cost colleges to lower-cost colleges, such as from private colleges to public colleges and from 4-year colleges to 2-year colleges.
• There is an increase in student and parent debt at graduation, especially at higher-cost colleges.

Stagnant wages and predatory loan administration have further exacerbated the problem.

Borrowers respond by choosing alternate repayment plans, such as extended and income-driven repayment, which reduce monthly payments by increasing the repayment term of the loan. This increases the total cost of the loans. It also means that the borrowers may still be repaying their own student loans when their children enroll in college.

But, most analysts do not believe that the student loan market will collapse in the way that the subprime mortgage market did. Most student loans are made by the federal government, not commercial lenders.

Student loan debt is also unsecured. Mortgages are secured by the homes that they were used to finance. When a debtor defaults on a mortgage, the lender can repossess their home and sell it to make up some of the difference.

However, student loans are essentially secured against something non-material — the borrower’s future earnings. Borrowers remain on the hook for the loan, as well as interest and collection costs, no matter what their financial situation. Even those who default face the possibility that their wages and tax returns will be garnished in order to recoup some of their debt. Bankruptcy is not a viable option, as most student loans are barred from discharge in bankruptcy proceedings.

Student borrowers who do manage to meet their debt obligations might need to postpone making major purchases such as homes and cars. And their capacity to make luxury purchases is, of course, also diminished. So will their ability to start their own businesses, to invest in financial markets, and to save for retirement. In an environment where wages have not kept pace with inflation, this will increasingly be the case for many graduates.

The fact that these consumers will be prevented from making purchases is likely to have a small collective drag on the economy. In March 2018 testimony to the Senate Banking Committee, Federal Reserve Chairman Jerome Powell stated: “As this goes on and as student loans continue to grow and become larger and larger, then it absolutely could hold back growth.”

The economic impact will increase as the previous generation enters retirement and begins spending more conservatively.

Some pundits have predicted that if the economic slowdown becomes perceptible enough, caps will be put on federal education lending. Some borrowing will shift to private lenders, but only for wealthier students enrolled at the most selective colleges. College enrollments at less selective institutions will consequently decrease, with fewer students able to access the funds to pay for their education. This could potentially contribute to the merger and closure of small, tuition-dependent colleges that do not recruit students nationally.

While there might not currently be a student loan crisis, the situation will get worse over the next two decades. The time to take action to prevent a student loan crisis is now, before the problems become more severe and more expensive to fix.

Proposed Solutions

A range of solutions have been proposed for this looming crisis.

A report from the Urban Institute suggested that mandatory credit counseling for low-income borrowers might better prepare them for dealing with their debt load upon graduation. And it also suggested that loan servicers be incentivized to put certain borrowers on income-driven repayment plans, thereby reducing their chances of defaulting.

The American Enterprise Institute recommends that institutions be required to share the burden of defaulted loans, therefore giving them motivation to ensure that they prepare students for financial success after graduation.

Draft legislative language for reauthorization of the Higher Education Act of 1965 from both Democrat and Republican education committees have included proposals to expand loan counseling for at-risk borrowers. The expanded loan counseling would be more frequent and would be personalized to the borrower’s circumstances. This could reduce default rates by making borrowers more aware of alternatives to default, such as income-driven repayment plans.

Education on default options, including loan rehabilitation and loan consolidation, which are intended to pull borrowers out of default by devising plans that allow for lower monthly payments, is also likely to help reduce default rates.

Senator Lamar Alexander has proposed payroll deduction of student loan payments, which would significantly reduce student loan default rates.

Others, notably 2020 Democratic presidential candidate Bernie Sanders, have advocated for free college, thus substantially reducing the need for student loans in the first place.