In an ISA, a borrower agrees to pay back a fixed share of her income for a fixed number of years, in exchange for money to fund her education. Private ISAs have never developed beyond a niche product in the U.S., and I predict they never will. [ii] Why? It’s extremely difficult for private investors to track income. The federal government, through the tax system, has the unique ability to both measure and collect from the income of U.S. taxpayers. The federal government is therefore uniquely situated to make unsecured loans to students who lack a credit record at an interest rate that would be infeasible for the private market.
The modern student loan program dates to 1965, when the Guaranteed Student Loan, now known as the Stafford Loan, was introduced. Private lenders provided the starting capital because then, as now, politicians were reluctant to increase the federal debt. Since banks put up the capital, it technically was not the government making these new student loans.
The role of the private lenders in the new program was limited to servicing the loans after borrowers went into repayment
But the federal government was firmly in control of student loans and bore all their risk. The federal government set interest rates, chose who would get loans, and capped loan amounts. The government also guaranteed banks a return on the loans and paid interest while some borrowers were in school. If the borrower did not pay off her loan (that is, went into default), the government paid the bank instead.
The role of the banks was limited: they took applications, disbursed the loans, collected payments, and kept records on individual loans.
During this era, the banks were essentially middlemen who bore almost no risk. Both the principal, and a minimum interest, were guaranteed by the federal government. As economic theory predicts, banks liked this risk-free profit very much. This was not a free market, by any standard definition.
Government has always played a central role in student loans in the U
During the 1990s, the federal government began offering Stafford loans without a private intermediary, through the new Direct Loan program. In this new program, the federal government took applications and disbursed loans, instead of the banks.
Direct Loans were, at the outset, an option to the existing loan program, which continued to make loans. Students didn’t shop between the two programs: rather, they borrowed from whichever program their college opted into. Unsurprisingly, the private banks that participated in the old program were opposed to the expansion of Direct Loans, which ate into their profits. An informal cap on the size of the Direct Loan program kept it at about a third of the loan market.
With the passage of the Health Care and Education Reconciliation Act in 2010, the federal Direct Loan Program became the sole source of federal student loans in the United States.
Private lenders no longer originate Morganton money payday loans federal student loans. They only service the loans on the back end, collecting payments and interacting with borrowers on behalf of the Department of Education. They still own some loans from the old program, but these are gradually disappearing as borrowers pay off their debts.
Student loans are a rare case in which economic theory gets it exactly right. Economic theory predicts, and history shows, that government will always play a central role in providing student loans. The free market in student loans to which some hope to return is one in which government bore the risk while banks enjoyed a healthy, risk-free return. Not one of the economics texts on my bookshelf defines a competitive market in these terms.
