Should Colleges Pay for Student Loan Defaults?

A college education does not come with a warranty. All a degree does for you, at least in theory, is open more doors of opportunity — it does not guarantee that you will get a job in your field.

However, college costs have risen sharply — over 1,100% since 1978, which is more than four times the cost increases in the Consumer Price Index (CPI). As a result, too many graduates are dealing with onerous levels of student debt, making repayment difficult if they do find a job in their chosen profession and nearly impossible if they do not.

With a tight job market and lower wages, college costs are reaching a critical mass. At what point do shrinking job opportunities make a college education not worth the costs? In the worst case scenario, continued price increases will eventually drive costs so high that graduates in critical but lower-paying jobs, such as teaching, will be unable to pay off the debts necessary to acquire their degree — and if they can, it will be at the expense of home ownership and other necessary economic drivers.

While it is unrealistic for colleges to guarantee a job to their graduates, it is reasonable to expect colleges to consider cost control measures to make their degrees more affordable. Unfortunately, there is little economic incentive for colleges to control costs while the demand for a college education stays high.

Federal and state funding has been trimmed in recent years, but the combined input from state funding and Pell Grants is still over $115 billion annually — providing a large pool of money to colleges to help sustain higher spending.

Various legislative proposals have been floated to give colleges a financial stake in the future success of their students. One interesting proposal with bipartisan support in Washington is to force colleges to pay for excessive levels of student default.

In a way, this rule already exists within the Department of Education. If over 30% of graduates from any school default on their loans within three years after starting the repayment period, that school can be thrown out of federal loan programs. Even with this low bar, a few schools have still managed to miss the goal but are generally given a second chance.

Newer proposals to rectify the situation may be similar to the bill introduced by Sen. Elizabeth Warren (D-MA) and Sen. Jack Reed (D-RI) in 2013. Their proposal was effectively to fine colleges with default rates above 15% and force them to pay back the government 5% of the total loan amount in default. The intent is to find a way to make schools share some of the borrowing risk with their students.

The Warren-Reed bill went nowhere, but forms of this proposal are getting a new bipartisan emphasis. It is likely to be folded into reauthorization of the Higher Education Act. The chairman of the Education Committee, Republican Senator Lamar Alexander of Tennessee, reportedly backs the concept.

As with most legislation, the real trick is how to accomplish the goal without invoking the Law of Unintended Consequences. The most likely consequence is that colleges will find subtle (and possibly overt) ways of weeding out students based on their ability to pay. It will be difficult to balance this goal without further harming diversity or creating a greater inequality gap.

Still, some effective risk-sharing effort for colleges is long overdue. When the final proposals come out, watch where the money is designated to go. Are any fines directed back toward helping students who have defaulted or are approaching default, or does the money just go back in to the general Treasury?

Unless such a fine or reimbursement scheme is tied in with a means of directly helping students, these proposals will be a step in the right direction, but will only solve one element of the problem. Let's see what evolves up on Capitol Hill.