What purpose do student loans serve?

If you were to ask someone what student loans are for without offering any context, you’d likely get some variation of “to pay for college, because many kids can’t afford it otherwise.” Such replies reflect an unexamined, embedded assumption that loans to finance higher education — and the pursuit of a degree itself — are intrinsically good ideas.

The Biden administration’s proposed student loan forgiveness program, and the challenges to its legality now before the Supreme Court, have placed student debt squarely in the public consciousness. Rarely in discussions about debt forgiveness — or the role of government in providing college loans — does the purpose and suitability of student loan debt ever arise.  Before considering the government’s role in financing higher education, it is essential to understand the function of student loans.

Deciding to borrow money for college is fundamentally a capital budgeting decision. As with a company considering an investment — in plant and equipment, working capital, or an acquisition — one considers whether the investment generates a positive net return. Going to college is an investment in human capital, and irrespective of how (and whether) it is financed, it has direct (tuition, fees, housing) and opportunity (foregone income) costs. Just as with other significant personal investments — purchasing a house or car, typically financed with residential mortgages and auto loans, respectively — borrowers can similarly calculate or intuit the expected benefits relative to the costs, and secure financing to match the term of the benefits received or asset acquired.

High school students and their families have safely assumed for generations that attending college is an overwhelmingly positive net present value (NPV) economic undertaking, with higher earnings potential more than compensating for its total cost, including the interest burden associated with student loans. However, as a purely financial decision, the notion that going to college is an economic “no-brainer” no longer may be so obvious. 

While studies continue to show that undergraduate degree holders generally earn 75 percent more over their respective lifetimes than do high school graduates, some experts believe the value of a degree to be fading in the face of rising college costs and a worker shortage increasing job opportunities and shrinking the wage gap. CNBC reports that a growing number of companies, including in technology, are dropping degree requirements altogether for middle- and even some higher-skill roles. At the same time, anecdotal tales abound of recent college graduates working low-wage jobs far afield of their academic majors. Relatedly, various academic studies also note that the economic benefits conferred by a college degree differ — sometimes materially — by program of study.

With growing uncertainty as to an undergraduate degree’s economic value, government’s involvement in financing higher education deserves heightened scrutiny. As the financial return analysis for students has become less sanguine, the justifications for the federal government’s role in the student loan market have become more complex.

Government arguably has a legitimate interest in making credit available for student loans. The incremental skills ostensibly acquired through higher education promote employment, wealth creation and higher tax revenues — certainly with regard to those students making an NPV-positive decision to pursue a degree. However, for NPV-neutral or negative decisions, the analysis is more convoluted. A brief recent history of the government’s evolving role in financing higher education is instructive.

Federal student loans, prior to 2010, originally had interest costs subsidized by the government, but largely originated by private lenders. Subsidizing such loans may be in the public interest even if the education they finance is value-destructive to the recipient — as higher aggregate tax revenues, the psychic value to the holder of a degree (even if not particularly financially rewarding), and the related benefits that accrue to society of a college-educated citizenry might all still ensue. Interest subsidies are plausibly a low price to pay for these advantages.

Beyond interest subsidies, having the government originate loans directly for NPV-negative investments in higher education, with the associated credit risk, is a harder case to make. Of course, a value-destructive decision to go to college doesn’t mean a loan can’t be serviced, but one would expect it to be more challenging. Additionally, a negative-NPV college decision might just as easily result in the holder becoming demoralized (vs. realizing positive psychic value from a degree) by the difficulty of servicing student loan debt with a low-paying job.

All of this brings us to our current pass. Just as the value proposition of higher education may be shifting, there is now a considerable quantum of government-held, economically impaired (i.e., not serviceable) student debt, much of it associated with institutions and degree programs of dubious value.

As a policy matter, direct government loans used to finance educational pursuits of doubtful worth might still be defensible provided that they: a) can still be serviced, even if value-destructive (meaning the student economically would have been better off having chosen a different degree program or not going to college at all, but the debt can still be repaid), or b) contribute to creating a public good.

The first prong is a straightforward underwriting exercise any prudent lender would undertake.  The second, however, is the unspoken rationale of the forgiveness movement — that, regardless of higher education’s economic value, a public good is realized from the government originating loans that may not be repaid (and also justifies their forgiveness).

The problem is that no societal consensus exists holding that such loans are, in fact, a public good. To the extent such arguments are made, they are usually of the “education is a good thing,” without further elaboration, variety. Moreover, the time to debate whether non-economic loans might still advance some larger social objective is before the money is lent, not after. 

What the loan forgiveness movement wholly elides is that a post-hoc giveaway engenders resentment among many non-participants, violates contract law, and weakens the public’s confidence in a fair and just public policy regime — all of which offset any public good that might be realized through loan cancellation.

In the current debate over student loans, it is critical to acknowledge what actually occurs when such loans are forgiven — a (belated) recognition that government-as-lender has facilitated an economically value-destroying transaction and socialized its consequences. A more honest reconfiguration of the student loan market would entail returning the lion’s share of student loan finance to the private sector, which will finance value-accretive investments in higher education and which the government can choose to subsidize in part (as it once did) as the resulting higher wages — should they materialize — and associated tax revenues are clearly in the public interest.

Government also may elect to directly finance economically value-destructive degrees, provided a societal consensus emerges concluding that such funding (for which the costs are socialized) is warranted. This might be more efficiently accomplished through grants or loans pre-wired for forgiveness if certain conditions are met.

The federal government subsidizes and directly funds myriad activities. Understanding the role — if any — that it should play in the financing of higher education begins with a clear understanding of, and societal agreement regarding, its objectives and consequences. Only then can a policy regime be crafted reflecting the people’s will in service of the public interest.

Richard J. Shinder is the founder and managing partner of Theatine Partners, a financial consultancy. Follow him on Twitter @RichardJShinder.