My Two Cents

Making Clear the Cost of Credit

Chris Farrell Jun 10, 2007

The New York Times has a compelling story on the surge in private student loans. The private student loan market is disturbing. Students are taking on too much of this debt. Interest rates are high, and poorly disclosed. The terms of the loans are unfavorable for the student, too, especially for young adults entering the job market for the first time. And, for no good reason beyond lobbying muscle, the industry managed to protect their loans from being discharged in bankruptcy in 2005.

As college tuition has soared past the stagnant limits on federal aid, private loans have become the fastest-growing sector of the student finance market, more than tripling over five years to $17.3 billion in the 2005-06 school year, according to the College Board.

Unlike federal loans, whose interest rates are capped by law — now at 6.8 percent — these loans carry variable rates that can reach 20 percent, like credit cards. Mr. Cuomo and Congress are now investigating how lenders set those rates.

And while federal loans come with safeguards against students’ overextending themselves, private loans have no such limits. Students are piling up debts as high as $100,000.

Banks and lenders face negligible risk from allowing students to take out large sums. In the federal overhaul of the bankruptcy law in 2005, lenders won a provision that makes it virtually impossible to discharge private student loans in bankruptcy. Previously such provisions had only applied to federal loans, as a way to protect the taxpayer against defaulting by students.

While federal loans also allow borrowers myriad chances to reduce or defer payments for hardship, private loans typically do not. And many private loan agreements make it impossible for students to reduce the principal by paying extra each month unless they are paying off the entire loan. Officials say they are troubled by the amount of debt that loan companies and colleges are encouraging students to take on.

Private students loans are just part of a much larger problem, one we deal with all the time on Marketplace Money. Four decades ago, credit redlining of minorities and low income families was commonplace. Women were systematically excluded from the loan market, too. For decades economists and regulators focused on the democratization of credit, breaking down barriers to legitimate lenders and opening up access to mainstream financial institutions. They succeeded.

Although there are still troubling incidents, denial of credit because of race, ethnicity, income and gender are largely behind us. For instance, the mailboxes of both low-income and middle-income families are stuffed with multiple credit offers. The problem today is deceptive practices from credit card companies, mortgage lenders and, it seems, purveyers of private student loans.

The democratization of credit is a public policy achievement. But times change, and the pendulum has swung too far from redlining to “greenlining.” The challenge is for regulators and economists to devise ways that make the the high cost of credit in all its forms very clear to consumers, to build in better incentives for lenders to stop much of their credit gamesmanship, and to ban some practices–like universal default with credit cards–that are abusive and wrong.

Will this dry up credit? I seriously doubt it.

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