How Private Student Lending Can Repair Higher Education

Photo by Sebastian Herrmann on Unsplash

By Beth Akers, Preston Cooper, and Joe Pitts

This report is a joint project with the American Enterprise Institute. For the AEI version of the report, click here.

Key Points

• Private student loans are a relatively small share of the market for higher education finance; however, scaling back the beleaguered federal student loan program would offer an opportunity for expansion.
• Private lenders have a financial incentive to steer students toward higher education options with a better return on investment.
• Private student loan expansion faces impediments, including practical problems with unsecured lending and a hostile regulatory environment.
• Federal student loans to graduate students and parents are the best candidates for privatization. Policymakers could use a portion of the savings from privatization to better support low-income students.

Executive summary

Federal student loans dominate the market for education finance, with privately originated loans accounting for just eight percent of outstanding student debt. But as the federal student loan program flounders amid high delinquency rates, administrative troubles, and enormous fiscal costs, many have suggested privatization as a potential solution. Privatization would involve scaling back or even eliminating the federal student loan program and allowing private lenders to fill the gap. Lenders would be able to set the terms of the loans they make and bear the financial losses if students fail to repay.

Turning over the responsibility for student lending to the private market has many potential benefits. Since private lenders would take financial losses if they lend to students who pursue forms of higher education with a low return on investment, they have an incentive to steer students toward institutions and programs where graduates typically earn enough to repay their debts. This would help more students realize the economic promise of college. Moreover, privatizing the federal student loan program would save taxpayers hundreds of billions of dollars; part of the savings could expand financial aid programs for low-income students.

Privatization does come with stumbling blocks that policymakers will need to contend with. First, private lenders may not adequately finance higher education with a low private value but high social value, such as training for teachers. There are also practical barriers to market expansion — most notably the lack of obvious collateral for most private loans — that may lead private lenders to underinvest in higher education. Finally, a hostile regulatory environment may stop private lenders from adopting modern underwriting techniques based on students’ expected return on investment. This may cause private lenders to overlook some students who could benefit from higher education.

The report concludes with several policy recommendations. Policymakers should focus on the federal graduate and parent loan programs, which together compose a majority of new student loan volume. It is possible to privatize these portions of the federal student loan program without dire unintended consequences. Privatizing the undergraduate loan program is possible, but such a reform should accompany other policy changes to improve the functioning of the private student loan market. These include expanded financial aid for low-income students and those in socially valuable programs — funded with the savings from privatization — and regulatory changes to allow private lenders to embrace high-quality methods of underwriting.

With bipartisan agreement that the federal student loan program faces major challenges, policymakers ought to consider privatization as a potential remedy. This report offers guidance for those interested in allowing the private market to play a larger role in higher education finance.

Introduction

Private student loans are the most broadly misunderstood element of America’s system of higher education finance. Even lawmakers seem unfamiliar with the contours of this aspect of how Americans pay for college. Democrats are often critical of private financiers, placing undue blame on them for the woes of the current state of student lending. And Republicans often conjure and pine for a return to a fictional past in which the student loan system was largely the product of private financiers making loans that were subject to the checks and balances of the private marketplace.

In 2019, Rep. Maxine Waters (D., Calif.) made an unfortunate public gaffe when she asked a panel of bank executives what they were going to do about the massive numbers of students defaulting on loans every year. “What are you guys doing,” she said, “to help us with the student loan debt?” Each bank executive on the panel offered, in turn, that they no longer made private student loans. While they were all too polite to say it, it was the federal government that had put the nation into the predicament it is in, and it would be the government that would need to get out of it. Private student loans weren’t the problem. Waters moved on quickly after the gaffe, accepting the grace that the panelists offered by not explicitly calling out her gross misunderstanding of the situation.

It’s easy to poke fun at Waters for this mistake, but the truth is that any number of her colleagues probably had the same misunderstanding but were lucky enough to not have voiced it so publicly.

And misunderstandings about the role of private student loans aren’t exclusive to Democratic lawmakers. Republicans have often expressed beliefs about private student loans that weren’t quite in line with reality. The most common misunderstanding comes from a policy change that occurred during the Obama administration. Before Barack Obama took office and before the Great Recession, some federal student loans were made by private banks using their own capital. However, the federal government set the terms of the loans, including student eligibility and interest rates, and guaranteed lenders’ profits even if students failed to repay the loans. This meant that private banks played a role in the process of loan origination, but the system was hardly a private market.

Soon after Obama took office, he signed the Health Care and Education Reconciliation Act (the Affordable Care Act), which ended all private-sector participation in the origination of federal student loans. The legislation ended government-guaranteed private loans, known as the Federal Family Education Loan (FFEL) program, and made all new federal student loans originate under the Direct Loan Program, which was administered and funded directly by the federal government.

Republican lawmakers often reference this legislation as a watershed moment, one in which market discipline was removed from federal student lending and contributed to the subsequent run-up in debt. There is a mistaken sense that the FFEL program was a private marketplace and that the discipline it imposed on student lending kept things from spiraling out of control. The truth is that FFEL wasn’t designed in a way that would allow private financiers who worked with the program to use any discretion, especially not the sort of discretion that would make things work better for borrowers. Nor did FFEL give private financiers any incentive to use such discretion, even if they’d had it.

Neither of these oft-conjured caricatures of private student loans are accurate nor particularly useful. Private loans aren’t to blame for the massive balance of outstanding student debt in the economy, nor would privatizing the whole system—as some conservatives would like—solve the problem of ensuring universal access to education while making sure student debt is affordable.

But it is an issue worth exploring further. Currently, private student loans — that is, loans originated and financed by private financiers — make up a small share of the new student debt issued each year. Students often turn to private student loans after they’ve exhausted all their personal resources and their eligibility for federal student loans, which are offered with terms that are often more generous than what the private market can offer. Most students don’t require private student loans to pay for their enrollment, but occasionally students’ financial need exceeds their personal resources and eligibility for federal student aid. In essence, private student loans work as a fail-safe that ensures that any borrower making a financially sound investment in their education will have the funds to do so.

Over time, the role of private student loans has been marginalized, with the maximum loan awards in the federal loan program increasing, sometimes dramatically, as in the case of graduate student lending. Each time the federal loan program expands the number of dollars that students can borrow, it further shrinks the market niche for the private student loan industry.

The expansion of federal lending and the associated contraction of private student lending may not be what’s best for the nation. In fact, federal dominance of student loans could be leaving the country worse off, and moving the financing of higher education to the private sector, at least in part, could lead to better outcomes for students and taxpayers.

The primary concern about the status quo is that students are graduating with student loan balances that are unaffordable based on their ability to earn. In many cases, it should be predictable that those loan balances are unaffordable; students are borrowing sums of money that will be burdensome to pay back with the typical earnings in their anticipated career. This happens because the federal student loan program does not underwrite borrowing. Students who apply for federal student loans receive access to the same level of resources, regardless of their likelihood of being able to repay it. For example, students can borrow the same sum of money to study fine arts as they can borrow to study engineering, despite the radical difference in expected earnings between those two majors.

This is an intentional policy design to ensure that students across different socioeconomic backgrounds have equal ability to pursue the field of study they are passionate about. Sadly, leveling the playing field on the front end has left some of the most disadvantaged students owing debts they can’t afford to repay on the back end.

While stories about unaffordable student debt grace the pages of major newspapers most days, we hear about unaffordable loans in other areas of consumer credit far less often. One reason is that when private financiers originate other types of debt, they go through a process called underwriting in which a lender determines if a loan is affordable for a borrower to repay. Another reason, of course, is that these other types of consumer credit generally offer an escape hatch: to liquidate the underlying asset and pay off the debt.

Simply bringing the practice of underwriting into the realm of higher education finance might go a long way toward preventing borrowers from ending up with unaffordable student debt.

While we conceivably could introduce some sort of underwriting into the federal student loan program, political support for such a move would likely be scarce due to the implications for equity and concentrated impacts on some institutions and their surrounding local economies. Moreover, there is no reason to think the federal government would be particularly effective at underwriting. A more promising avenue is allowing the private market to assume a larger role in student lending. An advantage of allowing private financiers to manage the process of underwriting is that their incentives are already aligned with the borrower: A lender doesn’t want to make a loan that is likely to end in default, just as a borrower wouldn’t want to take on a loan that he or she would struggle or fail to be able to repay.

The problem of unaffordable student debt is not only a problem for students who must struggle to repay and face the unfortunate consequences of default. The cost of originating unaffordable student debt falls directly on taxpayers, who fund student lending through their contributions to the U.S. Treasury. Moving some portion of student lending into the private marketplace would eliminate this burden on taxpayers and put any downside risk on private institutions that are more capable of managing them.

Despite the misunderstandings about private student loans, it isn’t wrongheaded to think that the status quo — the relatively little private market participation in student lending — isn’t ideal. In fact, we suspect a larger role for private lenders in education lending could vastly improve the current system of higher education finance. It is for this reason that we embarked on the inquiry that ultimately led to this report.

Our process began with one-on-one background conversations with representatives of several private student loan companies. Encouraged by the information we collected from these conversations, we brought together a group of private student loan companies and higher education experts for a closed-door meeting at the American Enterprise Institute in the fall of 2023. During that conversation, we spoke candidly with industry professionals and policy specialists about the state of the private student loan marketplace and prodded them to consider the challenges and opportunities that would come with a smaller federal student loan program. This report flows from the many insights shared during those discussions and our own independent research.

The state of private student loans

Portraying the cost of college as astronomical serves both Republican skeptics of higher education and Democratic advocates of larger government involvement. In politicians’ telling, the typical student must take on hundreds of thousands of dollars’ of debt just to get a bachelor’s degree. But in reality, very few students pay the eye-popping $75,000 price tags that elite universities advertise, as most students receive financial aid to cover part of their costs.

According to the National Postsecondary Student Aid Study, the median state resident student at a four-year public university paid just $4,500 in tuition after financial aid in the 2019–20 academic year. That figure rises to $13,300 at four-year private universities. Students and their families are also responsible for non-tuition expenses such as room, board, and textbooks. These vary depending on where a student attends college and whether he or she stays on or off campus, but the median four-year university estimates that such costs amount to $16,000 per year. The price of college attendance is considerable, but still much lower than commonly portrayed.

How students use loans to pay for college

Since the above figures reflect costs after all grant aid, students and their families must cover these costs either out of pocket or with loans. Federal loans made directly to students, known as Stafford loans, are the most common source of loan funding. Just over half of four-year college students used a Stafford loan in 2019–20. It is economically rational for students to cover their expenses with a Stafford loan first as these loans are the most heavily subsidized. Stafford loans carry below-market interest rates (5.5 percent in 2023–24), and Stafford borrowers have access to benefits such as the Saving on a Valuable Education (SAVE) Plan, under which many borrowers will not need to repay their loans in full.

Stafford loans have limits (up to $7,500 per year for dependent students), so after these are exhausted, some families turn to federal Parent PLUS loans to fill budget gaps. Students do not use Parent PLUS loans themselves; rather, parents borrow the loans on their children’s behalf. While effectively unlimited — parents may borrow as much as the university allows for tuition and living expenses — Parent PLUS loans are a worse deal than Stafford loans from the consumer’s perspective. Parent PLUS interest rates are much higher (8.05 percent in 2023–24) and carry a 4.2 percent origination fee. Parent PLUS loans are also not eligible for the generous SAVE Plan and many other benefits afforded to Stafford borrowers.

As a result, Parent PLUS loans are a moneymaker for the government. Parent PLUS borrowers repay $1.16 for every dollar they borrow, in present value terms. The upshot is that private lenders could theoretically offer students and their families a better deal on education loans and still make money.

Indeed, today some families turn to the private sector to help pay for college. Roughly 10 percent of four-year college students used a private loan in 2019–20. Unlike federal student loans, which are originated by the government and available to virtually everyone who wants one, private loans are originated by third-party financial institutions for the purpose of funding students’ education. Financial institutions make these loans because they yield profit, not because they are directed to do so by policy. They are not available to everyone; instead, private lenders selectively make loans based on borrowers’ perceived ability to repay.

The last resort for students and families who exhaust other sources of aid is a credit card. Credit cards typically carry interest rates above 20 percent, much higher than most private student loans. According to a Sallie Mae survey, seven percent of students and nine percent of parents reported using a credit card to fund at least some of their college expenses. Credit cards may be the alternative for students who cannot secure a private education loan.

What is the typical student’s experience with private loans?

Students and parents may approach private lenders independently or connect with private lenders through a preferred lender list from their university. Regardless of how the student makes contact with the lender, in almost all cases, the student’s university must certify that the private student loan amount is aligned with the student’s financial need.

As the private student loan market exists today, lenders will not lend to students unless they have a reasonable expectation of repayment. Traditionally, lenders rely on measures of creditworthiness — such as FICO scores — to make loan decisions, but these are less useful for student lending. Because many college students of traditional age lack a credit history, lenders often rely on cosigners to determine the likelihood that a loan will be repaid. According to Enterval Analytics, 87 percent of private student loans are cosigned, meaning the student secures the agreement of another party — usually a parent — to pay the loan if the student does not. It has historically been far more difficult for private lenders to accurately assess the likelihood of repayment for loans without a cosigner, discouraging them from issuing credit in these cases.

The terms and conditions of private loans share some similarities with federal loans. Most private loans offer students an in-school deferment and a grace period, meaning students do not have to make loan payments while they are enrolled in school and immediately afterward. However, several lenders we spoke to indicated that they incentivize and occasionally require students to make payments while enrolled. In-school payments reduce borrowers’ overall interest costs. More importantly, this practice gets borrowers into the habit of paying their loans; once payments are due, the thinking goes, these students will be far less likely to default.

Unsurprisingly, students are far more likely to use private loans at more expensive colleges. Among students whose annual tuition is below $10,000 after aid, 7.5 percent use private loans, compared to 13.1 percent of students whose net tuition exceeds $10,000.

Families toward the middle of the income distribution are the likeliest to use private loans. Use is lower among poorer students who typically choose less expensive college. Likewise, use is lower among richer students, who may have the family wealth to pay their tuition without private loans or access to cheaper sources of credit. While conventional wisdom holds that upperclassmen should be more likely to receive loans as they have more academic history on which to underwrite, juniors and seniors use private loans at approximately the same rate as freshmen and sophomores.

Most students who use private loans don’t take on an enormous amount of additional debt. The median four-year college graduate with private debt owes $15,000 to private lenders, stacked on top of $25,000 owed in federal Stafford loans. This compares favorably with Parent PLUS borrowers, who owe a median $26,000 in federal PLUS loans. (Most families that use private loans do not use Parent PLUS and vice versa.)

There is a wide distribution of private loan burdens, however. Upon graduation, one-third of college graduates who use them owe less than $10,000 in private loans, suggesting the existing market helps meet the needs of students who face small budget gaps. But there is also a long right tail to the distribution: students with substantially larger balances. Fifteen percent of college graduates who use them owe more than $50,000 in private loans.

The market for private student loans to graduate students is much smaller. Enterval Analytics reports that graduate loans comprised just 11 percent of private student loan originations in 2022–23, even though graduate loans made up 47 percent of originations of federal student loans in the same year. Like Parent PLUS loans, federal loans to graduate students have no effective cap. Unlike Parent PLUS, federal graduate loans are eligible for the SAVE Plan and a swath of other benefits, which means the government loses money on each dollar it lends to graduate students.

The private market in graduate lending is limited because private banks cannot compete with a federal loan program that loses money, while they can be competitive with the less generous Parent PLUS. However, before Congress removed caps on federal lending to graduate students in 2006, a robust private market in graduate lending did exist, and evidence suggests that private lenders offered graduate loans at interest rates comparable to those on federal graduate loans today.

What does the private loan market look like?

Enterval Analytics reports that the current outstanding balance of private student loans is $130 billion, representing just eight percent of outstanding student loans overall. (The federal portfolio amounts to $1.6 trillion.) This low percentage is largely due to smaller origination volumes in the private market: $10 billion in 2021–22, compared to $85 billion in federal loans during the same year.

However, the private loan portfolio is also smaller because private debt tends to be retired faster than federal debt. Federal borrowers may extend their repayment periods over decades through the SAVE Plan and other mechanisms; most private lenders do not allow anything comparable.

Private loan originations have grown over the past 10 years, despite a brief dip related to the COVID-19 pandemic. One reason for the increase is that Stafford loan limits have been frozen in nominal terms, meaning those loans cover a smaller proportion of the net cost of college each year. Students must turn to family savings, credit cards, Parent PLUS loans, or private loans to cover the difference.

According to the 2022 Survey of Consumer Finances (SCF), most private student loan borrowers pay interest rates in the high single digits; the median rate is five percent. The SCF also reports that just 1 in 10 private student loan borrowers pay an interest rate above 10 percent. These figures are likely to include many borrowers who have refinanced their federal debt with lenders such as SoFi, so the true figures could be somewhat higher. But it suggests that private loan interest rates are far from usurious, as critics of the private market often contend.

Around 4.7 percent of private student loan balances in repayment are delinquent, meaning the borrower has missed his or her payments by more than 30 days. Moreover, 1.5 percent of private student loan balances are severely delinquent, meaning the borrower is overdue on his or her payments by more than 90 days. Delinquency rates on private loans have gradually declined over time, though they have increased somewhat since the COVID-19 pandemic.

Delinquency rates on private loans compare favorably with delinquency rates on federal loans. In December 2019, over 12 percent of federal loan balances were delinquent — three times the rate on private loans — while seven percent of federal loan balances were severely delinquent, which is five times the rate on private loans. These delinquency figures on federal loans do not include the millions of borrowers who were in long-term default, meaning their loans had gone 270 days without payment and were transferred to a collections agency. Nor do the federal delinquency figures include borrowers who are not paying their loans because they qualify for a zero or reduced payment under income-driven repayment (IDR) plans; while IDR helps borrowers avoid the negative consequences of delinquency, IDR use is a signal that borrowers’ earnings are too low relative to their debt.

If a private lender deems a loan uncollectible, it typically charges off the loan after a set period of time. After a charge-off, the lender may still attempt to collect the loan itself or sell the loan to a collections agency. Cumulative charge-off rates are substantial. According to Enterval Analytics, roughly seven percent of private student loan balances originated during the 2012–13 academic year were charged off over the following decade. While data on the share of charged-off balances that are eventually collected are not available, charge-offs can represent a significant cost for lenders.

Borrowers still owe their debt after a charge-off, even if the debt is deemed uncollectible. But, contrary to popular belief, discharging private student loans in bankruptcy is possible. The bar for discharge is significantly higher than for other types of debt. According to the Consumer Financial Protection Bureau (CFPB), “the Bankruptcy Code provides a more difficult test for relief (a showing of ‘undue hardship’) and an extra step in the process (an ‘adversary proceeding,’ essentially a lawsuit within the bankruptcy).” It is easier to discharge private student loans that were not taken out to directly pay for tuition expenses.

Another important feature of the private student loan market is securitization, which occurs when lenders bundle loans together to sell to investors. This sale of loans provides lenders with fresh capital they can use to make new loans. The securitized pool of loans is assessed by ratings agencies to determine the risk that borrowers will default. Investors might not purchase securitized loans if ratings agencies do not have the data to assess default risk or if the risk is too high.

To determine default risk on private student loans, the rating agency Moody’s considers traditional creditworthiness metrics such as the presence of a cosigner and the credit scores of either the student or his or her cosigner. Moody’s also considers metrics such as school type and completion status. Proprietary schools carry a higher default risk, and dropouts are less likely to repay their loans. Private loans for one or more of these metrics are lacking (for instance, non-cosigned loans to students without a credit history) may therefore be more difficult, if not impossible, to securitize.

Innovation in and around private student loans

A traditional private student loan typically has a cosigner. Underwriting decisions therefore depend on the student’s or the cosigner’s credit history, rather than the expected financial returns of the student’s postsecondary education. Usually, the lender will seek to securitize the loan. But in recent years, various new models have emerged to break out of the traditional mold.

No-cosigner loans. Some smaller private student lenders, notably Funding U and Ascent, will make loans to students without a cosigner. Funding U determines loan eligibility based on “academic achievements and career path” rather than FICO score. However, this means freshmen and sophomores are less likely to be approved for loans since they have less academic history.

Ascent offers multiple types of non-cosigned loans. While eligibility for one type is based on credit history, another type bases eligibility on institution, major, and GPA, among other factors. The loan is only available to juniors and seniors.

Loan repayment assistance programs. Offered by Ardeo, loan repayment assistance programs (LRAPs) are financial products purchased by colleges to help students afford their loan payments. Conditional on graduation and starting full-time work, Ardeo reimburses a student’s loan payments if his or her income is below a set threshold, which varies depending on Ardeo’s agreement with each institution. Colleges benefit from increased enrollment and retention, since students are more willing to start and continue their studies with a guarantee they will not fall behind on their loan payments. While not a private loan itself, LRAPs can support the private student loan market by shifting the downside risk of nonpayment onto a third party.

Outcomes-based loans. A similar product to an income-share agreement but branded as a loan, outcomes-based loans tie the amount that students repay to their income after graduation. A notable player in this space is Edly, which offers an income-contingent loan to students without a cosigner. Edly’s borrowers do not make payments on their loans unless their income exceeds $30,000, and payments are based on their earnings.

The benefit of outcomes-based loans is downside protection for students: If their degree doesn’t have the job market value they hope for, they won’t be stuck with loan payments they cannot afford. The outcomes-based loan model has also been adopted at the state level by New Jersey.

Privatization’s promises and perils

The term “privatization” provokes winces from some and enthusiastic grins from others. Because of the politically charged nature of any effort at privatization — and because of its complexity — any initiative to expand the role of private student lending must rightly identify not only its promise but also its potential shortcomings. It is important to understand what privatization is good for, what the goals of student loan reform are, how such reforms might be implemented, and how to address the policy’s potential flaws. We aim to outline a balanced view of reform that accurately assesses the policy landscape, enabling future practitioners and thinkers to better understand how reform efforts can serve students and the common good.

In this report, we define privatization as abolishing or scaling down federal student loan programs to make space for private financial institutions to make education loans that the federal government might have previously made.

Central to the concept of privatization is that private financial institutions set the terms and assume the risk of student loans. The market can only work to improve the student loan system if lenders have both the discretion and the incentive to avoid making bad loans, which is only possible if lenders bear the risk of nonpayment. For this reason, we do not consider a return to the FFEL program — or any similar arrangement that sees the federal government guarantee private loans — to be true privatization. Nor does privatization, in our view, mean selling federal loans to private financial institutions, since those institutions would not have been involved in loan origination.

Instead, true privatization gives private lenders the freedom to make loans on their own terms and the responsibility of bearing the costs if students do not repay them. Under a privatized student loan system, the federal government could still intervene in the higher education market in other ways, such as providing grant aid. Privatization also does not preclude sensible regulation of private student loan markets. But a truly privatized student loan market must include privatized decisionmaking, privatized gains, and privatized losses.

The case for privatization

Most students attend college because they want to increase their employability and earnings potential. Survey data suggest that 91 percent of students pursue a college degree to “improve [their] employment opportunities.” Moreover, even students who do not see university education primarily as a means of economic advancement probably do not think it wise to take out a loan for an investment that is unlikely to pay off.

Yet many federally funded institutions of higher education have a poor track record of helping students secure good jobs that enable them to earn back the cost of college. These schools continue to receive federal funding, even though many of their former students struggle to repay their student loans. Private markets could fix this problem.

In theory, a robust private student loan market would see lenders issue student loans based on the student’s expected return on investment (ROI). ROI is the amount by which a student can expect to increase his or her earnings for having gone to college, minus the costs of college, including both tuition and non-tuition expenses. When the financial returns of college exceed their costs, ROI is positive, and lenders should want to make loans to fund programs such as these. Private lenders would shun colleges and programs where expected ROI is negative, protecting both themselves and students from “investments” in higher education that are unlikely to pay off.

A system of ROI-based private student lending could produce a host of positive outcomes. First, it would hold colleges and universities accountable for the economic value of their degree programs. By focusing on ROI, private lenders would deny loans for programs that place students in tens of thousands of dollars in debt but leave them without the credentials to secure a job with sufficient income to repay those loans. These programs leave students worse off financially than when they started. If we understand our higher education system as a means of socioeconomic opportunity and upward mobility, these programs fail their intended purpose.

While private lenders have often emphasized traditional creditworthiness metrics like the presence of cosigners and FICO scores rather than ROI, the rollback of federal student loans would mean that lenders would leave money on the table if they don’t fund high-ROI programs. As such, there would be a gradual tendency toward disciplining the higher education market to reward more lucrative programs.

To be sure, policymakers have occasionally tried to steer federal student loan funding away from low-ROI programs. This is the implicit logic of gainful employment (GE) rules, which attempt to use data on postgraduate student earnings to ensure that federal direct loans are only being used to fund degree programs that have a positive ROI. But as written, GE falls well short of this laudable goal.

Far from extending to all degree programs, GE standards apply to only a fraction of institutions of higher learning. As one of us previously highlighted in the Chronicle of Higher Education, even the Biden administration’s recent proposed expansion of GE would only extend to certificate programs and for-profit colleges. Less than a sixth of college students are in programs covered by the GE rule; around 85 percent are in programs that are not held accountable for their economic value.

This change does not bring thorough accountability: Every year, hundreds of billions of dollars in student lending flow to programs that may or may not be economically valuable, putting taxpayers on the hook for bloated institutions with few incentives to improve economic outcomes.

Furthermore, this bureaucratic route to accountability lays the system bare for private interests to exploit. Strong private lobbies and the political persuasions of incumbent officeholders sway how accountability is applied. Democratic administrations have been quick to apply strong GE rules to for-profit universities, while avoiding regulation that might upset public universities and nonprofits. Future Republican administrations, animated by concern about progressive bias in the halls of academia, may well use these same tools to punish “woke” elite institutions.

In the case of private student loans, however, the market does not arbitrarily discriminate between for-profits versus nonprofits, nor secular versus religious schools. Credit is extended based on an objective assessment of how profitable an investment in a degree program will be, not politics. There is simply far less temptation for lawmakers to carve out special exceptions when accountability is primarily a function of market forces, as opposed to federal rulemaking.

Looking at the numbers, the inefficacy of such measures becomes even more apparent. In 2022, a report produced by the nonpartisan Government Accountability Office revealed that direct loans issued by the federal government from 1997 to 2021 actually cost taxpayers $197 billion on net. The government had originally projected that these programs would yield a profit of $114 billion. These numbers do not incorporate the cost of the SAVE Plan and other loan-relief schemes introduced under President Biden.

Moreover, as mentioned in the previous section, federal student loans were delinquent at three times the rate of private loans and severely delinquent at five times the rate of private loans as of 2019. And federal student loan delinquency may be worsening. As of December 2023, 40 percent of federal student loan borrowers have not made a payment.

Federal accountability measures are simply not working, mostly because federal programs encourage indiscriminate lending with little to no regard for the amount borrowed, program quality, or a borrower’s ability to pay. Administrative issues have also plagued the federal student loan program. The Department of Education has struggled to coordinate with loan servicers, often not properly counting borrowers’ monthly payments and failing to determine when they are eligible for certain loan-relief programs. Recently the department has struggled to implement a new congressionally mandated student aid form, delaying millions of students’ enrollment decisions and prompting two investigations.

In addition to imposing price discipline on institutions of higher education and harnessing market forces to increase the economic value of their credentials — and doing so much more fairly and efficiently than federal regulations have or will — privatization would free up federal dollars. Policymakers could use these funds to reduce the deficit or expand scholarship programs for low-income students such as the Pell Grant.

Privatization of student loans could enable more targeted support for marginalized students and those pursuing socially valuable but lower-paying careers that require higher education credentials, while also saving taxpayers money on net. The need for fiscal savings is especially acute given the ballooning fiscal burden imposed by the federal student loan program under the Biden administration. Such proposals are explored further in later sections of this report.

The drawbacks of privatization

While privatization holds promise, critics charge that a fully private market for student loans would also result in several key drawbacks. After all, the current federal student loan regime is the result of policymakers’ and voters’ past concerns about the shortcomings of the private student loan market. Concerns about privatization fall into three main categories: access and equity, socially valuable but underpaid career paths, and the liberal arts.

Access and equity. Since the conclusion of World War II and the passage of the Servicemen’s Readjustment Act (commonly known as the “G.I. Bill”), American higher education policy has been guided by the North Star of “access.” The landmark Higher Education Act of 1965 and subsequent federal higher education reforms through the beginning of the 21st century can be viewed in this light. At the core of this effort to expand access was a simple premise: Higher education is a ticket to the middle class (or beyond), and by expanding it to more people, policymakers help actualize America’s commitment to equality of opportunity.

Critics worry that student loan privatization could restrict economically disadvantaged and minority students’ access to credit. Because private lenders often consider the presence of a cosigner or a lender’s parent’s credit score when choosing to lend to students, students from lower-income backgrounds or racial minority groups are at a disadvantage vis-à-vis students from middle- and upper-income households when seeking private financing for their education.

Underrepresented minorities are more likely to rely on federal student loans. Just 33 percent of white students received federal student loans in 2019–20, compared to 48 percent of black students. Moreover, 63 percent of students attending historically black colleges and universities (HBCUs) received federal student loans, versus only 34 percent of students who weren’t attending HBCUs. Since minority students disproportionately receive federal student aid, restrictions on federal aid could hurt them more than other groups.

The flip side of this argument, though, is that low-income and minority students are more likely to pursue higher education that does not pay off financially, meaning it could be more difficult for them to repay their loans. Private lenders, by screening out negative-ROI colleges and programs, could reorient the higher education market toward degrees that provide students with a better ROI. This would help low-income and minority students benefit more from higher education. Concerns about overall reductions in access, meanwhile, could be alleviated through targeted grant aid for disadvantaged students.

Students of any ethnicity or background do not benefit when they put themselves in debt they’ll never pay off. At the same time, universities receive exuberant taxpayer subsidies for degree programs of questionable value. Any policy “fixes” constructed to alleviate these concerns must avoid the current system’s deficiencies.

Socially valuable but underpaid career paths. Some professions that are essential to the functioning of society simply do not offer salaries that reflect their full social value. This is especially true for fields such as teaching and social work, in which most workers are employed by governments and hence salaries are not set through market forces. These professions may require extensive higher education credentials by law, but they often do not pay sufficient wages to pay off the debt people accrue to receive those qualifications.

The federal student loan program subsidizes such occupations through programs like Public Service Loan Forgiveness, which cancels the loans of public servants who might not earn enough to fully pay down their debts. A market-based student loan system, however, would be unlikely to offer these benefits. Student loan privatization might therefore exacerbate talent shortages in socially valuable but lower-salary jobs such as teaching.

A regime of privatized student loans could theoretically address this problem with more targeted aid for individuals pursuing or employed in socially valuable professions. Moreover, state governments and industry associations could revisit the stringency of higher education requirements for some of these professions, so students do not need to take on as much debt to enter them.

The liberal arts. Many claim that privatization could hurt liberal arts programs, due to their low ROI. Evidence of the tension between the liberal arts and ROI was on full display when West Virginia University, faced with a budget shortfall, scaled back several liberal arts programs. On the surface, this makes sense: programs that do not contribute as much economic value as other programs would be among the first on the chopping block. People with political power, such as Mississippi’s state auditor, have said as much, arguing for the state to focus its higher education investments on “practical” degree programs. But the full picture is far more complex.

A liberal arts education can be remarkably useful in the workplace. Many management consulting firms purposefully seek out liberal arts majors for their unique skill set, which includes adaptability, communication skills, and high emotional intelligence. A well-constructed liberal arts education not only encourages students to pursue knowledge for its own sake; it also forms people with critical thinking skills and depth of understanding. These traits are increasingly important in the private sector, particularly as artificial intelligence displaces many menial tasks.

While a liberal arts education is not primarily about workforce preparation, it may inculcate a remarkably economically useful set of traits among students. As American Enterprise Institute scholars Benjamin Storey and Jenna Silber Storey wrote in a recent report on civic and liberal education, “Acquiring this set of durable skills suits young people for not only civic life but also many kinds of work, and employers would likely value a degree that reliably indicates such training.” Indeed, most majors in English, liberal arts, and humanities see a positive — if modest — ROI in the long run. Private lenders would extend credit to support at least some of those programs.

Of course, the liberal arts retain a value that cannot be measured economically. Even before tuition inflation accelerated, people paid sizable chunks of money to attend liberal arts colleges, pursuing academic studies that didn’t translate directly into higher wages.

But has our expansive federal student loan system actually helped the liberal arts? Was it ever meant to? The decline in liberal arts programs has taken place under the current student loan regime, indicating that there are deeper forces at play that will not be remedied by federal student aid policy. At best, the current system is slowing the hemorrhaging — and at a high cost to taxpayers.

Rather than vaguely gesturing toward the decline of liberal arts programs as a reason to maintain the current student lending system, we should recognize that the status quo is not only setting taxpayer dollars on fire but also burdening liberal arts students especially with tens of thousands of dollars of debt. This is far from compassionate, and it’s doing little to support dying programs. Lawmakers who seek to expand access to the liberal arts should do so directly through grant programs or the creation of new schools of civic and liberal thought at the state level, rather than Kafkaesque repayment programs.

Impediments to expanding the private market’s role in higher education financing

In an ideal world, governments and private interests would fund higher education programs where the combined private and social value those programs create exceeds their costs. At the very least, private student lenders would extend credit to students enrolling in programs in which the expected financial return to the student exceeds the cost of the student’s investment. It is not ideal for private lenders to fund every program currently supported through federal loans, as these programs include many programs for which the value created does not justify costs.

Indeed, a major benefit of student loan privatization is that private lenders would do a better job identifying programs that produce good value, instead of indiscriminately funding all accredited schools as the federal government does now.

In theory, private lenders would be willing to fund every higher education program for which expected returns surpass costs. But in practice, a significant expansion of the private student loan market would need to confront several practical and regulatory hurdles before this ideal becomes reality. Privatizing the student loan market without addressing these impediments could yield a smaller and less functional private student loan market than proponents hope , thus leaving many prospective college students without the financing they would need to pursue and complete high-value credentials.

The barriers to private market expansion fall into two main categories. First, there are practical hurdles — or market failures — that prevent lenders from funding all positive-return programs. Second, there are regulatory hurdles — or government failures — that prohibit lenders from making value-creating loans or make lenders reluctant to extend such credit. Policy has a role in addressing both categories of impediment.

Practical impediments to private market expansion. Before a lender extends credit to a consumer, it must assess the consumer’s likelihood of repayment. The borrower’s FICO score is the most commonly used indicator of likelihood of repayment. In addition, private financial institutions making mortgages or auto loans typically require borrowers to put up collateral to secure the loan. Since the lender cannot fully assess the borrower’s ability to repay, the collateral serves as an extra layer of security for the lender. This additional security allows the lender to make loans to more consumers, or at least make loans at more reasonable interest rates.

Unfortunately, the private student loan market is far from the ideal. First, college students of traditional age often lack a credit history. Second, the asset that student loans finance — education — is intangible; lenders cannot foreclose on a borrower’s degree the way they can foreclose on a house or car.

These features of student loans may hamper the development of a robust private student loan market at multiple turns. If lenders cannot adequately assess a borrower’s ability to repay nor secure the loan with a tangible asset, they would have to offer interest rates far above the efficient level to justify the elevated risk. These higher interest rates may dissuade students who could benefit from higher education from pursuing a degree. High interest rates could also run afoul of usury laws. Many lenders could decide the student loan market is not worth their time — at least for borrowers without a creditworthy cosigner.

The lack of credit scores associated with loans to traditional-age students without a cosigner also presents problems for securitization. Lenders would find it difficult, if not impossible, to sell securitized student loans in the secondary market if those loans lack credit scores. This limits lenders’ ability to raise fresh capital to make new student loans.

Theoretically, these issues could be solved if lenders changed their underwriting practices to focus less on traditional measures of creditworthiness, such as cosigners and FICO scores, and pivoted to assessing whether the student and his or her intended program are a good match, likely to generate economic value. Under such ROI-based underwriting, lenders could use data on the institution’s typical graduation rates, expected earnings after graduation, students’ academic record, and their choice of college major to estimate each student’s ability to repay. This would theoretically allow lenders to make loans to promising students without a cosigner or a credit score.

Challenges remain, however. A private lender with an innovative new underwriting strategy would need to convince other financial institutions of its validity to sell securitized loans in the secondary market. One entrepreneur with a new idea is not enough to change the way the market operates; behavior changes from a broader swath of the financial sector would also be needed.

Moreover, several lenders we spoke to mentioned that ROI-based underwriting is more promising for juniors and seniors, who have a deep postsecondary academic record, have completed multiple semesters of college, and have chosen a major. It is more difficult to use student and program characteristics to underwrite student loans for freshmen and to a lesser extent sophomores. ROI-based underwriting methods would need to evolve in order to effectively de-risk loans to freshmen and sophomores, or else some students would not secure financing for the beginning of their education, at least not at reasonable interest rates.

Regulatory impediments to private market expansion. An efficient private market for student loans will require innovation, especially new methods of underwriting. New underwriting policies, however, may run afoul of regulations intended to protect consumers and prevent discrimination in lending. Though these policies are often well-intentioned, some may do more harm than good if they prevent private lenders from making loans for fear of adverse regulatory action.

The Equal Credit Opportunity Act (ECOA) rightly prohibits consumer lenders from discriminating against loan applicants on the basis of sex, race, ethnicity, and several other characteristics. But the ECOA and other laws governing fair lending go further in prohibiting consumer lenders from adopting lending policies that may be facially neutral but have a “disparate impact” on a protected class. The CFPB defines disparate impact as follows:

“Disparate impact occurs when a creditor employs facially neutral policies or practices that have an adverse effect or impact on a member of a protected class unless it meets a legitimate business need that cannot reasonably be achieved by means that are less disparate in their impact.”

Even if lenders do not intend to discriminate, they still may violate federal law if the practical effect of their policies is reduced access to credit for certain groups. This exposes lenders to lawsuits or adverse actions from regulators like the CFPB.

Consider a private student lender that wishes to make loans only to schools where the cohort default rate (CDR) on federal student loans is below 10 percent, meaning fewer than 10 percent of students miss a year’s worth of payments on their loans shortly after leaving school. Obviously, it is reasonable for a private lender to expect that the default rate on federal loans could predict whether the private loans it makes to students at the same institution will be repaid. But using CDR could nonetheless run afoul of the ECOA, especially considering the law’s ambiguity and the CFPB’s enforcement authority.

According to federal data, the median CDR at four-year institutions where a majority of students are white was 5.5 percent in fiscal year 2019. But at four-year institutions where a majority of students are black, the median CDR was 14.3 percent. Refusing to lend to students who attend colleges with high default rates would have the practical effect of disproportionately excluding black students from credit. This could run afoul of the ECOA, even if discrimination was not the lender’s intent.

The CFPB has explicitly cited underwriting based on default rates as a potentially prohibited practice under disparate-impact law. In 2012, the agency wrote:

“Private student lenders’ use of CDR . . . may present fair lending concerns because . . . racial and ethnic minority students are disproportionately concentrated in schools with higher CDRs. Accordingly, use of CDR to determine loan eligibility, underwriting, and pricing may have a disparate impact on minority students by reducing their access to credit.”

The same logic holds for other seemingly neutral factors that private student lenders may wish to use in determining loan eligibility and interest rates. Such factors include an institution’s completion rate and its students’ median earnings after graduation, both of which are indispensable to an ROI-based underwriting model. While it is not explicitly illegal for lenders to use any of these factors in making lending decisions, many lenders are justifiably worried that using such factors will expose them to lawsuits or regulatory attacks. Fear of litigation, heightened by the CFPB’s often unpredictable enforcement decisions, paralyzes lenders.

As a result, many lenders that might otherwise adopt new underwriting models in a more permissive regulatory environment instead fall back on traditional measures of creditworthiness such as cosigners, credit history, and FICO scores. While using these characteristics to make lending decisions also has a disparate impact, lenders fall back on them because they are “grandfathered in.” As Aaron Klein of the Brookings Institution writes:

“A set of existing metrics, including income, credit scores (FICO), and data used by the credit reporting bureaus, has been deemed acceptable despite having substantial correlation with race, gender, and other protected classes.

…

New data and algorithms are not grandfathered and are subject to the disparate impact test. The result is a double standard whereby new technology is often held to a higher standard to prevent bias than existing methods. This has the effect of tilting the field against new data and methodologies, reinforcing the existing system.”

Ironically, the current state of disparate-impact law means private student lenders are incentivized to discriminate in some cases. Because regulators dissuade private lenders from updating their underwriting methodologies to emphasize ROI, most fall back on traditional measures of creditworthiness, which may discriminate more heavily against protected classes than ROI-based models. For instance, a low-income black student whose parents have poor credit scores may find it difficult or impossible to secure a private loan, even if he or she attends a high-quality institution with stellar student outcomes. But a higher-income white student attending a low-quality school may find it easy to secure a loan if his or her parents have good credit scores.

Regulators’ overreliance on traditional measures of creditworthiness extends beyond disparate impact. To guard against bank failures, regulators require banks to hold back a certain amount of capital relative to their risk-weighted assets. Assets deemed riskier are subject to higher capital requirements, meaning it is costlier for banks to hold these assets.

Using ROI-based models to underwrite private student loans could result in a loan portfolio that includes many borrowers with little to no credit history. When lenders attempt to securitize these loans and sell them to banks, the loan-backed securities could be considered riskier assets than they actually are. This could trigger unnecessarily heavy capital requirements for the banks that purchase the securities. Private lenders will be more averse to making loans that will be more difficult to securitize, even if the loans themselves have a high likelihood of repayment.

Policy options

Policymakers seeking to privatize all or part of the federal student loan program correctly identify several benefits from such a policy. A private student loan market would impose more price and quality discipline on higher education, since private lenders have a profit motive and would not finance postsecondary education where students are unlikely to earn back their investment. This stands in contrast to the Direct Loan Program, through which students can get loans largely regardless of educational quality.

However, privatization advocates must be cognizant of several issues that scaling back or abolishing the federal loan program would create. First, private lenders might inadequately fund education for which expected financial returns are low but funding the education is desirable for nonfinancial reasons, such as supporting lower-paid public service professions. Second, there are key practical and regulatory barriers to the creation of a private student loan market in which all positive-return educational investments are funded.

Privatization of the federal student loan program, in whole or in part, has merit. But policymakers should consider additional policies to complement a privatization initiative, including expanded grant aid and regulatory changes to facilitate a more vibrant private loan market.

Privatization: where to start. Certain parts of the federal student loan program are stronger initial candidates for privatization. The best place to start is the grad PLUS program, which provides effectively unlimited loans for graduate students who exhaust their eligibility for graduate Stafford loans, which are capped at $20,500 per year. The only people who use grad PLUS, therefore, are graduate students who wish to use more than $20,500 per year in loans. Research has found that this increased loan availability has an inflationary impact on graduate school tuition.

Grad PLUS is a strong candidate for privatization because this niche of student loans has been private in the recent past: Grad PLUS was only created in 2006, and before that, graduate students found credit on the private market. A study by Monica Bhole found that the private market replaced grad PLUS loans almost completely; what’s more, most graduate borrowers obtained private loans at interest rates below the federal interest rate. A well-functioning private market would likely emerge again should the federal government eliminate grad PLUS loans.

Policymakers should also be comfortable privatizing the graduate Stafford loan program, which provides graduate students with their first annual $20,500 of credit. The vast majority of graduate students are older than 25 and therefore should have an established work and credit history that private lenders can use to underwrite loans. Moreover, graduate students have demonstrated their capacity to succeed in an academic setting, as they have by definition completed a bachelor’s degree, and so lenders face much less risk that the graduate students they fund will fail to complete their programs. Graduate Stafford loans are also the largest single component of the student loan program, at $25 billion in disbursements per year.

The Parent PLUS program, which lends to parents of dependent undergraduate students, is also a strong candidate for privatization. Parent PLUS loans have high interest rates and result in a net profit for the government, suggesting that private lenders could undercut the federal interest rate and still make money. (Indeed, many parents opt for private rather than federal loans to fund their children’s education.) Parent PLUS loans also make little sense in principle: because the student rather than the parent derives the financial benefit from higher education, it makes little sense for the parent rather than the student to take on loans associated with college costs. Indeed, the federal government allows many parents who cannot afford them to take on Parent PLUS loans , and these parents repay the loans at predictably low rates.

Some low-income parents may not be able to secure loans on a private market, but giving loans to parents who cannot afford them is not a desirable feature of the federal loan program and certainly not something policymakers should encourage from the private market. It is better to address this concern with targeted grant aid for vulnerable students, as we discuss further in the next section.

Undergraduate Stafford loans, which total $32 billion in disbursements per year, are the most difficult category of federal loans to privatize. Undergraduate students are simply riskier for lenders to loan to, since undergraduates often have no work or credit history and have a much higher risk of non-completion than graduate students. While we believe a private market in undergraduate student loans can thrive, such a market would be more successful if tied to other significant policy changes, as we discuss in the next two sections.

Regulatory changes. As mentioned, there are serious regulatory hurdles facing the private student loan market, should lawmakers roll back federal lending programs. Notably, the current ECOA language and its enforcement by the CFPB heavily discourage lenders from using projected earnings or other relevant factors during the underwriting process, forcing them to fall back on FICO scores. This doesn’t just tie lenders’ hands and significantly reduce the market’s ability to enforce price discipline, it also deprives a host of students of access to credit and thus artificially constrains the size of the market that private lenders could otherwise serve.

Lawmakers should consider amending the ECOA to create more regulatory certainty for lenders. Congress could provide explicit legal protection for the use of metrics such as projected earnings and expected debt-to-income ratios. Clarifying the ambiguities in the current law would assuage lenders’ fear of litigation, expanding access to credit for students who lack mature credit histories or willing cosigners.

While such reforms to the ECOA ought to precede rolling back federal undergraduate lending, they need not necessarily be in place to privatize federal graduate loans. Graduate students tend to be older and possess more mature credit histories. Moreover, as mentioned previously, we had a large and functional graduate lending market as recently as 2006, before the creation of the grad PLUS program. Nonetheless, ECOA reform would benefit both prospective undergraduate and graduate students alike, holding undergraduate and graduate programs accountable for their ROI.

These reforms would actually reverse discriminatory outcomes in many cases. As stated earlier, lending contingent on FICO scores or cosigners disproportionately excludes minority students and students from economically disadvantaged backgrounds, since they are less likely to have mature credit histories or eligible and willing cosigners. Under a regulatory regime in which lenders can take projected earnings and other similar measures into account, students from these backgrounds would have a better chance of securing access to private credit.

Underwriting for student loans should be based on outcomes, not the whim of federal regulators.

Reforming bankruptcy protections. While many believe that student loans are impossible to discharge in bankruptcy, that’s actually not true, though it is extremely difficult to do so. Federal statute stipulates that someone must prove they are facing an “undue hardship” in order for them to successfully discharge their student loans.

This standard is left undefined under law, leading jurisdictions to define it in various ways, creating divergent tests to determine whether someone is truly facing an undue hardship. Some states even require borrowers to demonstrate there is “certainty of hopelessness,” a high bar to reach. In addition to these lofty legal standards, the process of seeking dischargement is grueling. Borrowers must initiate a separate “adversarial proceeding,” often facing the lender and their lawyers.

The extreme difficulty presented by dischargement is usually justified insofar as student lenders are often giving loans to borrowers who lack collateral or credit histories. This logic makes sense under the current regulatory regime, which largely confines lenders to considering FICO scores when lending to students. If lenders, however, were enabled to use measures such as projected earnings while underwriting student loans, they should also bear the brunt of making bad loans, which includes making student loans more easily dischargeable in bankruptcy. As we stated earlier: True privatization gives private lenders the freedom to make loans on their own terms and the responsibility of bearing the costs if students do not repay them.

Additional grant aid. If the federal student loan program were fully privatized tomorrow, many students — especially graduate students and those with creditworthy cosigners — would undoubtedly secure loans at reasonable interest rates. Many undergraduates without cosigners would still access loans, provided they are exceptionally well prepared for college and enroll in an institution with an excellent track record.

However, the practical and regulatory barriers to a fully fledged private student loan market detailed in this report mean that lenders may not finance all students whose expected private returns to education exceed their costs. This is especially a concern for lower-income students, who may lack the liquidity to fund higher education on their own, even if the economic benefits would justify the cost in the long run. Moreover, private lenders are less likely to fund education with large societal returns but smaller individual returns.

Private lenders are also less likely to finance freshmen, who lack a college-level academic record and may not have declared a major. Young students emerging from high school rarely know precisely what they want to study: switching degrees is common for undergraduates, particularly early in their academic careers. A student receiving a loan for mechanical engineering may soon discover he or she doesn’t enjoy the curricula and declare a biology major instead. Freshmen may also drop out of college entirely. It is relatively difficult, then, for lenders to underwrite an undergraduate loan without assurance that a student will “stick with” their declared major, or stick with college entirely.

For these reasons, an economically efficient higher education policy — that is, one that ensures education is funded when private and societal returns exceed costs — may require additional government subsidies should federal student loans be privatized.

Student loan privatization would free up space in the federal budget, which policymakers could use to fund additional subsidies. According to the Congressional Budget Office, the federal student loan program will cost taxpayers $249 billion between 2024 and 2033 — and these costs are likely to rise once President Biden’s overhaul of student loan repayment plans fully phases in. While policymakers may wish to apply those savings toward reducing the deficit, they could use a portion to address some of the drawbacks of student loan privatization.

This report does not intend to lay out a comprehensive plan to overhaul college subsidies, but instead suggests guidelines for policymakers to follow as they approach this question.

First, Congress should avoid a return to the pre-2010 era of privately originated but federally guaranteed student loans. This “private in name only” student loan regime, as Jason Delisle describes it, negated nearly all the benefits of student loan privatization, since private lenders bore little to none of the risk of loan nonpayment and thus had no incentive to impose discipline on the higher education market. Guaranteed student loans also had a higher fiscal cost than direct loans made at the time.

It’s better for policymakers not to intervene with subsidies in the private student loan market itself, since these subsidies distort the incentives facing private lenders. Instead, lawmakers should target subsidies at students.

Congress could use some of the subsidies from student loan privatization to provide additional targeted aid for low-income students. As an example, repurposing half the savings of student loan privatization would enable a 37 percent increase in Pell Grant spending over the next decade. A Pell Grant expansion would reduce low-income students’ need to borrow; some might be able to avoid student loans entirely, while others might borrow reduced amounts from private lenders. Reduced borrowing would make low-income students’ debt-to-earnings ratios after graduation look more favorable, boosting the likelihood that they will secure a private loan. Policymakers could also front-load a portion of the Pell Grant expansion — meaning larger grants for freshmen — to help first-time college students cover their costs without borrowing, to address the difficulty of lending to underclassmen.

Policymakers might also consider creating programs to help students pursue lower-wage but socially valuable careers such as teaching and social work. While one possibility is to create dedicated scholarship programs to support students pursuing degrees in these fields, assistance for lower-wage public servants should not be contingent on their education levels. The optimal policy would be for Congress to top up the salaries of public service workers through tax credits. For instance, a $2,000 annual tax credit for teachers would cost $7.4 billion per year, or one-third of the estimated savings from privatizing student loans.

Decoupling subsidies for public service workers from the education system would reward workers of all educational backgrounds, whereas routing subsidies through colleges fuels credentialism by providing greater benefits to workers who attain higher levels of education. A teacher with a master’s degree benefits more from Public Service Loan Forgiveness than a teacher with a bachelor’s degree, but under a tax credit system, both would benefit equally.

Conclusion

Higher education finance in the United States today relies on the federal student loan program, which observers across the political spectrum believe is broken. Student loan privatization ought to be on the table as a solution to some of the problems facing federal higher education finance: inconsistent ROI, high fiscal costs, and administrative headaches. The obvious candidates for privatization are the grad PLUS and Parent PLUS direct loan programs, which increasingly face scrutiny from the left and the right. Nonetheless, lawmakers should not rule out privatizing the entire federal student loan system.

Student loan privatization should not involve a return to the FFEL program or any other regime that involves taxpayers guaranteeing private loans. True privatization means that private lenders enjoy the benefits and bear the consequences of their lending decisions. Lenders must have both the incentive and discretion to finance only programs they expect will lead to a good ROI for students.

To that end, private lenders should be permitted under law to use novel metrics such as projected earnings when underwriting loans. This would allow them to serve more borrowers, especially younger borrowers who lack mature credit histories or willing cosigners, and hold institutions of higher learning accountable for programs of dubious value. An ROI-based system of private student lending would not provide sustained funding to colleges and degree programs that fail to pay off.

Moreover, privatizing the federal student loan program would save taxpayers tens of billions of dollars. Some of the savings could contribute to deficit reduction, while a portion could fund expansions of grant aid to address the shortcomings of privatization. Policymakers could expand financial aid for low-income college students, while directly supporting individuals to pursue socially valuable careers such as teaching.

American universities remain the envy of the world, but the dysfunction of the federal student loan program has broken the promise of higher education for too many students. As a result, this coveted status is at risk. While there is a role for the federal government in helping students access higher education, policymakers should consider that the U.S. government’s 60-year adventure into student lending has done more harm than good. Student loan privatization, along with other sensible changes to financial regulation and federal grant aid, would help ensure students come out ahead when they pursue college.