Policy Analysis | October 2011

Student Loan Debt: The Rising Risk to the Recovery

Jonathan Watts Hull

President Obama announced a plan to ease the student loan debt burden for low-income graduates this week in a speech at the University of Colorado's Denver Campus. The president announced a change in the income-based repayment plan, reducing to 10 percent of their discretionary income (from 15 percent), two years ahead of schedule, the cap on graduates' federal student loan repayments. The program also provides a handful of procedures for the forgiveness of loan balances following a history of on-time payments. The proposal also allows some graduates with multiple student federal loans to consolidate them into one, potentially lowering their interest rates. The president's announcement could provide relief to a potential 6 million borrowers. The final component of the announcement is the "Know Before Your Owe" project, which is being developed by the new Consumer Financial Protection Bureau as a tool to help students and parents compare aid packages across institutions.

While student loan debt has been a slowly simmering issue for the past few years, it has recently picked up steam. As the economy has continued to slog along with very slow growth, colleges are graduating record numbers of certificate and degree-holders who have accumulated record amounts of debt. In much the same way that securities backed by essentially worthless mortgages undermined the economy in 2007, the exploding levels of student loan debt could prove to be another threat to the economy. In accelerating the student loan debt relief, the Obama Administration is hoping to defuse this risk by leaving more money in the pockets of recent graduates and expunging debt that remains after a reasonable amount of time in the workforce has passed.

Rising Student Debt and Delinquencies

A front page article in the USA Today last week sounded the most recent alarm on student debt, projecting the total amount held in student loans to surpass $1 trillion either by the end of this year or early next year. The article highlights the economic harm this lingering consumer debt could have, particularly because student loan debt is disproportionately held by those who are just beginning their independent economic lives. Elsewhere, the Wall Street Journal noted that the class of 2011 graduated with an average student loan debt of $22,900. The concern is that student loan indebtedness will delay a host of important economic and personal decisions for those who hold the debt, including starting new businesses, purchasing homes, and starting families. Moreover, individuals entering the workforce with large student loan balances are at greater risk overall for personal bankruptcy, particularly in a period of limited employment options and depressed wages.

Data from the New York Federal Reserve Bank illustrates the current trends in personal debt. Since the onset of the Great Recession, the number of student loan accounts has risen significantly, from just under 47 million accounts in the second quarter of 2007, to nearly 79 million accounts in the second quarter of 2011. At least two-thirds of graduates of four-year institutions carry some debt, a figure that is much greater (nearly 85 percent) for those students who were eligible for federal student aid, a proxy for lower incomes. At the same time, credit card accounts have dropped, from almost 475 million accounts in the second quarter of 2007, to less than 390 million in the second quarter of 2011 (after credit card accounts hit a low of 377 million accounts in 2010). This change has meant a narrowing of the gap between credit card debt and student loan debt. In 2007, total credit card debt stood at $800 B in the second quarter, compared to $350 B for student loans. By second quarter of 2011, credit card debt had dropped to $690 B, while student loan debt increased to $550 B.

Student loan debt is the only kind of consumer debt tracked by the Federal Reserve that has been on an upward trend in recent years. Since the end of 2009, mortgage, home equity, auto loan, credit cards and other debt have declined (significantly for credit cards), even as student loan debt climbed by more than 25 percent. When student loan indebtedness is removed from the total consumer debt picture, the composite debt figure over the past five years reflects a 4.23 percent decline in outstanding obligations.

The growth of student loan debt is matched by an upward trend in delinquencies on these loans, increasing 2.5 percentage points over this period (compared to an increase of 2.8 percentage points in credit card delinquencies and a more than 5 percentage point increase in delinquencies in home mortgages). While there are more delinquencies on credit card debt than student loan debt (and greater balances), the increased amount in new delinquencies for student loan debt exceeds credit card debt by $2.86 B, indicating student loan holders are having a more difficult time meeting their obligations (and that possibly those student loan holders facing difficulty hold greater balances).

College Costs Rising, Public Support Falling

While news of the president's proposal may have brought relief to graduates struggling to repay student loans, it may have little impact on the amount of overall student indebtedness due to another factor mostly outside the president's control. On the same day that the Mr. Obama presented his plan in Denver, The College Board released its annual Trends in College Pricing report for 2011 on college costs showing that the average cost of postsecondary education continued to climb, up 8.3 percent for in-state tuition for a four-year degree from just one year ago (driven in large part by California, although removing that state's increase only adjusts the average to a 7 percent increase). The increase is thought to be less than it could have been absent federal stimulus spending which helped to offset reduced state funds available for higher education. With federal funds exhausted and state revenues still depressed, it is likely that college costs will continue to rise, perhaps even faster, in the years to come.

According to The College Board, state appropriations per full-time student dropped by 9 percent between 2007-2008 and 2008-2009, by 6 percent the following year, and by 4 percent most recently. At the same time, tuition and fees at four-year institutions rose by 9 percent above inflation in 2009-2010 and 7 percent the following year. Public support for higher education had increased throughout the 1980s and 1990s, a trend that allowed tuition to remain steady or only increase modestly. With the 2001 recession, however, public support for higher education began to slip, picking back up during the recovery of 2003-2006, only to slide again (by 18 percent in real dollar terms) between 2007 and 2010.

Higher college costs matched with a slumping economy, and the accompanying drops in state support for higher education, are likely to lead to higher tuition at colleges and universities resulting in even greater student debt burdens. As has been observed elsewhere, even as the federal government increased its support for higher education, it was insufficient to cover the increased costs, shifting the burden to families. The most recent changes in higher education finance, increases in Pell Grants and a large tuition tax credit increase, have provided assistance to low-income students and those from families earning more than $100,000, but those in the middle are being increasingly squeezed.

It is not unreasonable for states to want to shift the cost burden of higher education to individuals (and families), particularly in times of economic hardship. Individuals are the primary beneficiary of certificates and degrees and should, therefore, make the greatest level of investment. On the other hand, states benefit economically and socially from an educated workforce, benefits that extend far beyond the pool of graduates. Furthermore, research institutions can be catalysts for economic growth, most especially in areas of innovation and technology. Additionally, without careful structures in place to avoid exclusion, increased tuition and fees for higher education represent insurmountable barriers to participation, and the benefits that accrue, for low- and middle-income families, ossifying already intractable obstacles for social and economic advancement and stunting the promise of the American Dream. This issue of access and affordability was discussed in EdNotes on the Issues in May.

What complicates this picture further is that there has been a steady increase in the number of students participating in postsecondary education. The swelling ranks of these students are a major factor in the explosion of student loan debt. It also points to a broader distribution of this financial obligation across the economy. If these certificate and degree seekers are successful in completing their studies, their earnings potential should offset the debt, but only after time. Depending on the degree, the field, and the economy, however, postsecondary degrees can return the cost of investment in as little as a year (for associates degrees) to a decade or more (for professional and graduate degrees).

The Next Bubble?

While sounding the alarm over both rising tuition and student debt, economists have raised the possibility that higher education is the next bubble. It is not hard to see how this could be. Student loans are among the easiest credit to qualify for, they carry relatively long terms, and they are not directly collateralized. Additionally, following a Congressional rewrite in 2005, student loans are not expunged with personal bankruptcy, meaning this debt will continue to follow a borrower even past a personal financial disaster.

The core of the bubble theory is that as an increasing number of students pursue higher education, the value of their degrees will eventually plateau or even decline as the pool of available talent swamps the range of opportunities. Essentially, the value of a college degree is not, in this line of thought, intrinsic to the degree itself, but rather a component of the scarcity of the degree relative to the demand for it. Indeed, there may be signs of oversupply in some fields, most particularly business and law schools. While is it beyond the scope of this discussion, any developing bubble in higher education is as much a factor in the mismatch between degrees conferred and demand in the labor force. For some employment fields, most particularly technology, science- and engineering-related firms, report a continued tight market, while graduates in the liberal arts may find themselves working at positions that do not require a college degree. Law school enrollments are off by more than 11 percent this year as Congress pushes law schools to disclose job placement and debt data for their students (law student debt averages $68,827 for public schools and more than $100,000 for private law school students). For medical school graduates, the debt picture is even worse: the average educational indebtedness of medical school graduates in the class of 2010 was nearly $158,000.

Countering this, however, is the hard, historical data that points to increased earnings for individuals with postsecondary education. According to research, "a typical college graduate has earned enough by age 33 to compensate for being out of the labor force for four years, and for borrowing the full amount required to pay tuition and fees without any grant assistance." No one graduate is typical, however, and there exist vast distinctions in the workforce outcomes for various degrees conferred, with some (particularly those in STEM fields) returning their investments far sooner than others. The problem, as University of California professor of higher education Norton Grubb pointed out to the Economist in April, is not that college isn't "worth it," but that as there are no longer any other routes to better incomes, the bar has been raised for even a middle-income salary, from a bachelor's degree to a master's or professional degree.

Going Forward

It is difficult to say whether the United States is reaching a tipping point with respect to college debt and costs. The president's acceleration of debt relief for graduates does not alter the structural problem graduates face, diminished employment prospects and high debt loads, nor does it resolve the issue prospective students face of increasing costs and decreasing levels of grant aid, most particularly need-based grant aid. Solutions at the federal level are likely to be constrained by the need to rein in the federal budget deficit. State options, including loan forgiveness for students who work in targeted fields, have been pared back in recent years due to state budget constraints. Expanding two-year college participation in state grant aid programs and providing state-structured support for financial aid to students at these institutions would offset the trend of lenders away from these institutions, and would serve to provide a foundation of support for low-income students pursuing postsecondary education. Inevitably, however, state policymakers will be faced with the dilemma of a population educated and trained for an innovation economy without the economic independence to drive it forward or one free from debt but perhaps without the skills and knowledge to compete in the global marketplace.