As rising student debt levels have grabbed the attention of policymakers, one idea in particular has garnered a ton of national attention: the notion that the federal government should enable existing federal loan borrowers to “refinance” those loans at current interest rates.
We’ve written about the problems with this idea in the past (see here and here). In short, offering a retroactive rate reduction to all federal loan borrowers provides the biggest benefits to those with the largest debts – whether or not they are at risk of default – and provides limited help to those on the verge of default. Thus, refinancing is an expensive and wasteful way to help struggling borrowers.
Despite its shortcomings as a policy, though, the proposal remains a top-tier talking point among Democrats, including presidential candidates Hillary Clinton and Bernie Sanders. Republicans in Congress are almost certainly feeling pressure to come up with their own alternative, preferably without the downsides of Democratic plans.
Enter legislation from Sens. Kelly Ayotte, R-N.H., and Shelley Moore Capito R-W.Va., that would “allow borrowers to refinance their federal student loans into the private market” by offering private lenders a 95 percent government guarantee against default on the loans they refinance. The bill would also create a tax deduction for employers who make payments towards an employee’s refinanced loan.
As with Democratic refinancing plans, this proposal has the political appeal of giving existing borrowers the benefit of lower rates. By moving loans off the government’s books and into the private sector, it is also more consistent with Republican desires to increase the market’s involvement in student financing.
A win-win? Unfortunately not. Federal loan borrowers can already refinance their loans with any private lender willing to do so – see companies like SoFi and CommonBond, for example. The issue is that most borrowers (outside of the least risky) won’t be able to find a willing lender because their federal loans are already heavily subsidized; low federal rates leave little margin for private firms.
To get around this, the Ayotte/Moore Capito bill offers a government guarantee to induce private lenders into taking on loans they wouldn’t touch otherwise. This would leave virtually all of the risk of refinanced loans with taxpayers, while private firms get the upside. Allowing employers to make pretax payments toward such loans (and only those loans) only sweetens the deal.
Thus, the legislation does the same thing as the Democratic proposals: It lowers rates for all borrowers, including many that could refinance in the private market right now without a guarantee. But instead of spending lots of taxpayer dollars to lower rates directly, it gives private firms a sweetheart deal to do it instead. The public-private entanglement doesn’t clearly add any value to an already flawed idea, and the employer tax break simply raises the cost of the whole thing.
The Ayotte/Moore Capito bill echoes Republicans’ spirited defense of the guaranteed lending program that Democrats eliminated in 2010 – where private lenders provided the capital for federal student loans in return for a government guarantee and additional subsidy. Many in the party, including presidential candidates Mitt Romney in 2012 and Carly Fiorina today, continue to criticize what they see as a “nationalization” of a functioning marketplace in private student loans.
The truth is, the guaranteed lending program was not a functioning market at all. It was a crony capitalist one. Guarantees and subsidies ensured lenders weren’t on the hook for loans that went bad. Lenders also had little discretion in terms of to whom they could lend, limiting the key underwriting role they play in real private markets. And while lenders did have flexibility to compete on interest rates, many chose instead to woo colleges in order to get on their preferred lending lists, showering college administrators with gifts and kickbacks.
In short, while Republicans are right to look to the private sector to help fix higher education, they have a worrisome tendency to embrace anything labeled “private” in the student loan market – regardless of whether it is an effective means to achieving their goals.
In this case, a better approach would be to leave refinancing entirely to the private market that already exists and spend our energy on other reforms that can help borrowers without breaking the bank. First, Republican policymakers have an opportunity to streamline and rationalize the system’s bewildering and often wasteful array of repayment options so that struggling borrowers can link payments to their income more easily.
Second, facilitating the growth of private finance products that are truly independent of government – like income-share agreements and forward-looking private loans – would leverage the power of the market without the distortions and giveaways that inevitably accompany government involvement.
To truly make headway on student debt, Republicans must do better than simply attaching a private facade to flawed existing programs or reform proposals. Instead, they should seize opportunities to reform existing programs, while also creating space for the private sector to help students avoid bad loans in the first place.
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