The Consumer Financial Protection Bureau recently floated the idea of allowing private student loans to be wiped out in bankruptcy. Despite the objections of some (such as the Wall Street Journal) this is a good idea. Private student loans should be dischargeable in bankruptcy, while federal student loans should not be. To see why, it helps to take a step back and think about lending in general. Impersonal lending works better when there are safeguards to protect borrowers from lenders, and safeguards to protect lenders from borrowers. How do student loans stack up in this regard?
Let’s start with federal student loans. When it comes to protecting borrowers from lenders, student loans have two big problems. First, widespread loan availability allows colleges to raise their tuition, which hurts students. Second, given human nature and the uncertainty and risk involved in investing in education, it is to be expected that some students will borrow too much, with obvious negative implications for their financial health later in life.
To safeguard against these dangers, the government established loan limits, both yearly and cumulative on how much students can borrow. For example, dependent students can borrow $5,500 to $7,500 per year, with a cumulative loan limit of $31,000 over their undergraduate years. Such limits help mitigate the danger that colleges will raise tuition and the danger that students will borrow too much (though note that the cumulative limits for independent students and grad students are much less helpful on these points).
When it comes to protecting lenders from borrowers, student loans have one big problem – a lack of collateral. Since the lender cannot repossess your education if you don’t pay your loan back, and since students typically have few assets right after graduation, students could theoretically just declare bankruptcy right after graduation to have their debt wiped out. To protect lenders from this, the government has made student loans non-dischargeable in bankruptcy.
In other words, the basic structure of federal loans is ok because it preserves a balance. You can quibble with the particulars, but they get the big picture right – there are safeguards to protect borrowers (loan limits) and safeguards to protect lenders (non-dischargeability). However, for private student loans, both safeguards are not present. In particular students can borrow more than the loan limits.* As Rich Vedder and I noted, this is a bizarre loophole:
what is the rationale for setting limits on the total amount students can borrow in the federal loan programs, but then allowing private student loans to circumvent those limits?
There is none. Yet since 2005, private student loans have been non-dischargable in bankruptcy.
Thus we have a situation in which private student loans do not have safeguards for borrowers, but do have the safeguards for lenders, which is a recipe for abuse of borrowers (in this case, lender encouraged overborrowing). The remedy is to either subject private student loans to the existing loan limits (add borrower safeguards), or to make private student loans dischargeable in bankruptcy (take away lender safeguards).
*Some federal student loans fall into the category of not enforcing reasonable limits as well, particularly the PLUS and Grad PLUS loans.
Photo Credit: Andrew Bossi