Andrew Gillen over at the Center for College Affordability and Productivity challenges my post yesterday on how PLUS loan denials could be used as a tactic for driving some borrowers toward private loans.

One of the certainly pertinent questions that Gillen raises is why would a lender deny a borrower’s PLUS loan application if they then run the risk of having that borrower go elsewhere and take out a loan with another company.

I would say that at least part of it comes down to the monopoly that many lenders have at various schools and even in some states.  In 2007, the U.S. Department of Education sent a letter to 921 schools in the Federal Family Education Loan (FFEL) Program that had more than 80 percent of their volume with a single lender. That’s a pretty large group of schools right there where a monopoly would have probably allowed this to happen. And that doesn’t count other schools where a lender may hold 50 percent or so of an institution’s volume.

But a second factor may be behavioral on the part of the student. Here’s an excerpt from what Student Lending Analytics wrote about private loan borrowing behavior based upon research by the Federal Reserve Board:

Private loan purchasing decision

• Rationale for choosing private loans:  “Families turn to private loans due to time constraints, incomplete funding to cover all costs of education, and ineligibility for Federal aid.”
• Frequency of comparison shopping:  The incidence of comparison shopping varies, with many going with the first loan offered to them.

This suggests that the denied PLUS applicants may be less likely to shop around, perhaps based upon the assumption that if that lender turned them down so will everyone else. In that case, if a lender denies a PLUS loan but then offers a private option right away, it may be very attractive to the parent. Especially if they are pressed for time and concerned about finding the last piece of the financing puzzle.

Instead of using them as a tool to shift parent borrowers into private loans, Gillen suggests that PLUS denials may be a reflection that the returns lenders get on PLUS loans are not worth the risk. That argument certainly seems plausible enough—why would a company extend a $20,000 line of credit to someone, even with a 97 percent guarantee, when their expected repayment isn’t very good.

But this raises two further questions. First, if lenders feel like the risk of  a PLUS loan isn’t worth it, shouldn’t they have similar feelings about Stafford loans? The different interest rates charged to borrowers are irrelevant because the subsidy paid to lenders once the borrower leaves school is identical on both loans—3-month commercial paper plus 1.79 percentage points. Lenders can also run a credit check on on Stafford borrowers and could deny them if they desire. But you never hear stories about students having trouble getting a Stafford loan, or having to use the emergency lender-of-last-resort loan program that borrowers can use if their loan application is denied.

Second, part of what plays into that profitability calculation is the option of getting the parent to take out a private loan instead. If a car dealer only has Chevrolet Cavaliers, then that’s what they would sell. But if they have the option of selling a more expensive Cadillac, wouldn’t they try to steer at least some buyers toward that? I’d imagine the same calculus comes into play with PLUS versus private loans.

In terms of acceptance and denial rates generally, it seems clear that there are decent numbers of PLUS borrowers with bad credit. Intuitively, this makes sense. I’d guess that most parents with the best credit probably would use a home equity loan instead of taking out a PLUS loan because the rates are lower. But the issue is not with the rate of PLUS loan denials, it’s the difference in that rate between the two programs. I can’t believe that the borrower populations in the two programs is so different that the denial rate in FFEL would be double what it is in the Direct Loan Program. And that’s what caused the red flags to go up.

Overall, my issue isn’t necessarily with the usage of credit records in this situation. It’s the opaque and black box nature of it. We have no way of knowing if lenders are using different underwriting standards based upon a borrower’s institution, familial income, or whether they once dyed their hair green in eighth grade. That issue coupled with the fact that these same lenders making the denial decisions also have the ability to market a competing and more expensive product makes me concerned that there are too many opportunities for a conflict of interest. If PLUS loan eligibility continues to be determined by using credit checks, that’s fine, but it seems like the denial rate information certainly makes the case that these should be standardized and clear-cut.