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Why Rising Student Loan Rates Aren't the Real Problem

Yesterday, interest rates on new federally subsidized Stafford student loans doubled from 3.4% to 6.8%. The move brought an angry response from students and parents who could see their financing costs soar if the government doesn't take action to reverse the move.

Taking positions that have students have to pay more for their college educations isn't popular. But all the attention on student loans distracts from the real root of the problem for students: the increasing disconnect between the value of an education and the price that colleges and universities charge for it.

More proposals than you can count
Lawmakers have no shortage of rate-reducing alternatives to consider. Both President Obama and House Republicans suggested tying interest rates to the prevailing yield on 10-year Treasury bonds, with differing margins added on for various types of loans. For instance, the House plan would set Stafford loan rates at 2.5 percentage points above the 10-year yield, with parental PLUS loans getting a 4.5-percentage-point add-on.

Other proposals have used a variety of other benchmarks. Sen. Elizabeth Warren suggested using the Federal Reserve discount rate of 0.75% as the prevailing rate, while two other Democratic senators suggested using the short-term three-month Treasury bill rate as a baseline for loan rates. Several lawmakers are working on possible extensions that would temporarily keep the old 3.4% rate for another year or two.

Getting rid of loans entirely
The government response to the college-cost crisis focuses on the wrong part of the problem. That's not particularly surprising, given that addressing interest rates on student loans simply repeats the government's own bipartisan fiscal mistakes that have irresponsibly ignored the need to avoid incurring excessive debt in the first place.

In response, students have to be smarter about making financially savvy choices about their education. There's plenty of evidence that there's room for improvement on that score:

  • When you look at how much you have to pay for college tuition, there's little correlation between tuition cost and reputation or post-graduate job prospects. Indeed, lower-cost state schools often rank better than a wide variety of private schools with much higher costs.
  • As a Wall Street Journal opinion piece by Prof. Glenn Reynolds of the University of Tennessee recently noted, a Fidelity study found that 70% of 2013 graduates have college debt averaging more than $35,000. Yet half of new graduates are unemployed or underemployed in professions where a college degree isn't really a necessity, leading to the question of why they incurred the debt in the first place.
  • The worst-case scenario for students is incurring large amounts of debt without actually completing a degree program. As Fool contributor Morgan Housel noted earlier this year, institutions with the lowest graduation rates tend to have higher default rates on the loans their students incur, yet 40% of full-time four-year students don't get degrees within six years, and 75% of community-college students don't finish within three years.

On the other hand, students do seem to be making some moves that indicate greater fiscal responsibility for their own financial lives. Just last week, for-profit educational institution Apollo Group (NASDAQ: APOL  ) reported sharply lower enrollment, including a 25% drop in new students. ITT Educational (NYSE: ESI  ) saw more modest declines when it reported in April, but new student enrollment was still down 3.6%. A new investigation last month from the SEC over Corinthian Colleges (NASDAQ: COCO  ) marked just the latest in a string of regulatory crackdowns on for-profit educational institutions. More generally, increased government scrutiny as well as reports of higher student-loan default rates among many players in the for-profit industry compared to nonprofit educational institutions have led would-be students to question the value proposition for-profit educational companies offer.

Supply and demand
Of course, there are plenty of interested parties who want the student-loan business to continue to grow in some form. Student-loan specialist Sallie Mae (NASDAQ: SLM  ) as well as big banks that make student loans earn substantial profits from their loans, and federal guarantees greatly reduce the risk that lenders take on with some loans, making the absolute level of interest rates much less important for certain types of lending.

But the real question going forward is whether students will start making tough decisions about whether traditional nonprofit colleges and universities give them more long-term value than their tuition costs. As long as schools have more people applying for admission than they have spots to fill, it'll be tough for students to get the pricing power they need in order to drive their tuition costs down. Eventually, though, reining in tuition costs will be the prime determinant of the financial health of students after they graduate -- not the rates they pay on student loans.

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Read/Post Comments (6) | Recommend This Article (2)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 02, 2013, at 10:40 AM, 2smartforlibs wrote:

    We all know this money isn't staying the loan program anyway. This is going right to Obama care reeducation. SO unions and government employees can explain to you why your wrong for thinking Obama care is a scam

  • Report this Comment On July 02, 2013, at 11:21 AM, grahamsway wrote:

    Excellent article.

    The biggest issue might be the environment that perpetuates the myth that everybody needs to go to college. Maybe that's the case, but if it is then we are in big trouble.

    I grew up in a middle class neighborhood and my father graduated high school and my mother immigrated here without graduating rom high school. They were able to raise two kids who were able to go to college, buy and end up owning a decent house in a good neighborhood and pass away without any significant debt.

    They weren't exceptional cases. Pretty much 90% of the neighborhood had a similar story though some families had 4 to 6 kids.

    The issue might be, what are the odds of this scenario playing out today? If the odds aren't very good, why not?

  • Report this Comment On July 02, 2013, at 1:11 PM, merchantilist wrote:

    Of course, immigration reform proposals will make all of this much worse. Foreign graduates particularly in technical fields will get automatic green cards. These are in unlimited numbers. It does not matter whether there most qualified Americans are unemployed or not.

  • Report this Comment On July 02, 2013, at 2:27 PM, edgemont1 wrote:

    You can educate student ' until the cows come home' as the saying goes on thining smarter about loans but this will not solve the problem. There is two major factors that need to be addressed. The first one is to restore full bankruptcy protection to students. If the government and banks know there is a possibility of bankruptcy discharge they will think twice on their lending practices. This point leads into the second point in that the Feds need to stop handing out student loan money like it is candy. You can take out 10000 a semester with no questions asked. Where in our market system can you take 10000 with no questions asked. Not even a credit check. This point leads into the third point and that is to set up a grant program where students would have to join the military or do community service for two years after they graduate. Gradaute students could be structured in a similar pattern.

  • Report this Comment On July 02, 2013, at 6:47 PM, AllenElliott wrote:

    Who thinks rising tuition spurs more people to attend collage?

  • Report this Comment On July 02, 2013, at 10:55 PM, Jarrod32 wrote:

    Nobody seems to be talking about the connection between subsidized student loans and college tuition costs. When students can get loans for whatever amount they need, there is not much incentive for colleges to keep costs down. The existence of subsidized student loans puts upward pressure on college tuition costs. When you subsidize something, you will get more of it...

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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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