The case for student loans

Published May 17, 2012

Are student loans a good way to finance a college education? The return on an investment in higher education is substantial. The employment rate and earnings potential for college graduates are much higher than for those without a degree. Education is a long-lived asset, much like a home or a car, and it may make sense to finance it in the same way, with a loan to be repaid as the asset is enjoyed.

We often hear alarm expressed over the size of the debt that some students incur, usually in the tens of thousands of dollars. The total amount of student debt is now over $1 trillion. In an effort to keep the default rate low, student loans cannot be discharged in bankruptcy. At present, the interest rate is 3.4 percent, but this subsidy is at risk as there is a measure before Congress to double the rate.

Student loans

Economics provides a solid reason to borrow for an education. It is an asset that yields returns that are more than sufficient to repay the loans. Some majors, of course, have a higher return than others, but across the board the importance of a college education has never been greater. Contrary to Rep. Virginia Foxx, the North Carolina Republican who opined that student loans let students "sit on their butts," the loan obligation should have an opposite effect. Loans incentivize harder work in college as they must be repaid by the student.

With global competition requiring a more educated workforce and citizenry, is it good public policy to encourage student borrowing while reducing state support? Public finance principles argue that it is because taxpayer-financed higher education results in a transfer of wealth toward those who will be wealthier after they complete their education; a transfer from low- to higher-income individuals. In addition, when a student leaves the state, the taxpayer's investment in the education of that student is lost.

As our public policy moves to replace existing subsidies and grants with market rate student loans, we must recognize that private credit markets will still require some governmental support. Access to loans is unequal across income levels. The private loan market works well for people of means, because lending requires guarantees in the form of collateral. However, education creates human capital, not physical capital. Unlike a house or equipment that can be used as collateral on a mortgage or business loan, the value of the educational asset cannot be used as collateral on an education loan. Unlike a house, human capital cannot be repossessed in the event of loan default — indenture went out a few centuries ago. Consequently, the market for education loans is different than the market for physical assets. The role for government is clear: Private sector banks will not initiate these loans without some government guarantees.

Investment of time and effort

How students allocate their time is key to the development of their human capital. Many spend too much time working at low-wage jobs when the return on their educational investment would be much greater if they were studying. This effort to "work one's way through school" makes grades suffer, reducing the human capital that their education is designed to establish. Too often, pressed for time, they drift to college majors that are easier to pass, and they concentrate on accumulating course credits rather than focusing on acquiring a deeper understanding of the subject matter. Used properly, loans allow students to devote more time to their studies, to get better grades, to major in more rigorous subjects, and to double major so as to acquire an education with breadth and depth. Loans can pay for themselves by reducing time to a degree, allowing graduates an earlier start to the desired career for which they are better prepared.

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Charles O. Kroncke, at far left, is associate dean in the University of South Florida College of Business. William L. Holahan is a professor of economics at the University of Wisconsin at Milwaukee.