Deferring the Future – The Direct Loan Program’s Subprime Problem

The stream of discouraging news regarding college costs and student debt hit another milestone following a report by TransUnion, showing that more than half of all students are now in deferment on their student loans.  Despite record amounts of federal spending on financial aid, students are falling further behind on their debt obligations, and the amount owed continues to explode.

According to TransUnion, 53 percent of student loans were in deferment or forbearance as of March 2012, totaling $388 billion in debt.  That’s up from 44.3 percent a year earlier, and a 75 percent increase in outstanding loan volume since March 2007.  No matter how one looks at the data, the numbers aren’t good.

The discouraging aspect of the data is that federal student loan programs are intended to provide needy students with more favorable loan terms than they could secure in the private sector, with the assumption that the federal government will be a more benevolent lender.  The ability of students to defer payments on their student loans was an example of this benevolency, allowing students who have hit a rough spot a chance to get back on their feet.  Students exhausting their deferment eligibility may also take advantage of forbearance options, which further push out repayment obligations.

However, deferment was never intended as a repayment management strategy for the majority of borrowers.  While the temporary relief it provides may be necessary for some students experiencing hardship, the accrual of interest on the loan balance while the student is in deferment can be a big penalty – one that grows the longer a borrower stays in deferment or forbearance.  The federal government also has no interest in helping students move out of deferment or forbearance, eventually resorting to fairly draconian measures to ensure a borrower repays their loan, by garnishing wages and even Social Security checks.

In contrast to the status of most federal loans, private student loans are far more likely to be current.  The delinquency rate on private student loans is less than half the rate for federal student loans, and that rate has declined over time.  Critics of private sector loan providers may argue that the terms on private student loans are less generous than federal loans, but when compared to a loan in deferment, it may not be as clear a contrast after the federal government adds interest penalties to a borrower’s loan obligation. 

As troubling as the growth in deferments is, equally troubling is the impact on the federal budget.  Direct lending relies on a revolving flow of cash to remain current, using the money from loans in repayment to make new loans.  As the number of new loans accelerates and the incoming repayments slow down, the Treasury has to make up the difference.  As noted in a previous post, the gap between what should be coming in and what Treasury has had to provide is accelerating, and could even become a $2 trillion problem by the end of another decade of runaway lending.  It’s time to rethink our government-centric student loan model.  It should be clear to any observer that direct lending is not the benevolent program many believed it to be – not for students or taxpayers.