Direct Student Loans in the Changing Landscape
of Higher Education Finance

A Commissioned Paper

Martin Kramer 1994

Large numbers of today's students would not be in college at all if they had to depend on just one source of financing--on their own resources, or on their parents', or on the funds of institutions, or on public subsidies, including student aid. In this sense, all of these parties are indispensable partners in the financing of post secondary education as we know it.

Any significant change in the terms on which any of the parties participates therefore raises the question: How are the other parties likely to react? The Direct Loan Program is such a significant change. Students, routinely offered new repayment options, are likely to see their role in financing as more manageable. Colleges and universities, as originators of loans, are likely to see the inclusion of a student loan in an individual aid package (and its amount) as a matter of institutional policy amenable to fine tuning.

But how are parents, traditionally the first recourse in paying for college, likely to react? How large a role will they be willing to play? Will they expect their offspring and Federal and state governments to do relatively more or less? The environment in which all of the Federal student aid programs are funded and administered.

This essay suggests that the crucial factor influencing parental attitudes is likely to be how good an investment higher education is perceived to be--the outlays involved in making that investment weighed against the returns it is expected to produce.

Background

The changes brought about by direct lending will be desirable in themselves. It will be easier and more convenient for students (and presumably parents also) to obtain educational loans. It will be easier for colleges and universities to carry out considered and consistent student aid policies in reliance on the continued availability of loans. Student borrowers will have several repayment options that will enable them to manage their indebtedness more comfortably and more in accord with their other life choices. For the first time, an income contingent repayment plan will routinely be one of those options.

These obvious advantages are not, however, by any means the end of the story. The American system of higher education finance has been highly unstable since World War II. The GI Bill period was followed by one in which parents and state governments (the latter through institutional subsidies) paid most of the bill. This period, in turn, was followed by one in which Federal student aid, in the form of both grants and very advantageous loans, took over an important part of the burden. By the late 1980's, however, the role of Federal and state grants was much reduced, loans were available in larger amounts, but on much less advantageous terms, and students were relying in a major way on their own earnings, probably more than ever before.

Will the Direct Loan Program, when fully implemented, usher in yet another era in the finance of higher education? Before trying to answer that question it is worth taking a look at the sources of the instability experienced in the last forty years. One of the sources has been intentional and laudable in itself: Many more students with relatively few family financial resources are participating in higher education than forty years ago. There are more students with, on average, larger claims on the resources provided by other parties to the financing system. It is also hard to fault another source of instability: The claims of other social priorities on Federal, state and philanthropic funds have become increasingly competitive with the claims of higher education.

If higher education must simply live with these two sources of instability, there is another which is less acceptable and may actually be reversible, if only with enormous difficulty. It is the tendency of colleges and universities to seek quality in ways that almost always cost more money. The costs that the parties to higher education finance must bear increase, even as competition for resources from other social priorities becomes more acute.

Given these sources of instability, a very powerful dynamic of buck-passing takes over. Federal and state governments want to shift more of the burden to parents and students. Colleges and universities want affluent parents to help pay the costs of educating students from low income families through higher "sticker price" tuition. Parents want any or all of the other parties to relieve them of some of their burden. These are not impossible dreams: At any one moment the apportionment of shares is according to no fixed ratio and no convincing rationale. Thus, the hope of shifting burdens to others is both an attractive and a feasible prospect.

It is beyond the scope of this paper to deplore this instability or to suggest remedies for it. It nonetheless sets the context in which we have to think about what the system of higher education finance will look like when the Direct Student Loan Program becomes part of the accepted landscape. How will the pushing and shoving that accompanies the unstable allocation of financial burdens work itself out, given the options presented by the new program? How, in particular, will the role of parents be affected?

It would be rash to try to forecast family finances very far into the future--that is, to forecast the financial base that will determine the ability of parents to pay. This ability will depend on such factors as savings rates, buoyant or sluggish income growth, number of earners per family and equity in home ownership. Different economists will make different predictions about these factors, depending upon which of a wide range of economic scenarios they see as most likely.

However, the inclination of parents to provide resources (as distinguished from their ability to pay) will in most cases be influenced by two factors: the costs of the higher education enterprise and the economic returns to obtaining higher education. These are powerful factors because they tend to determine, other things being equal, the price of higher education (tuition) and whether it is deemed to be worth that price. Price and economic returns are only two of the factors influencing how much parents can be persuaded they ought to pay, but they are almost certainly more pervasive factors than social, cultural or purely intellectual aspirations. There may well be a significant lag in parental perception of changes in price and returns, but eventually they make themselves felt.

These two factors give us four possible cases to examine:

• Scenario One: High returns to education and stable, or lower, constant dollar costs (reflected in stable, or lower, real tuition).
• Scenario Two: High returns to education and continuing rising costs (and tuition).
• Scenario Three: Low returns to education and stable, or lower, costs (and tuition).
• Scenario Four: Low returns to education and continuing rising costs (and tuition).

Each of these scenarios has implications for parental attitudes and for pressures on public policy and administrative action. They do not, of course, illuminate all the questions we may have. For example, they do not enable us to predict how cost restraint might occur, if it occurs. (Through lower salary costs? Higher workloads? The three-year degree?) And they tell us very little about whether costs(and tuition) at public and private institutions are likely to diverge or converge. Still, each of the four scenarios is worth examining.

Scenario One--High Returns to Education and Stable or Lower Costs (and Tuition)

This case is, of course, the most attractive from everyone's point of view. Because of effectively controlled real costs, state institutional subsidies would go farther. Parents' savings for the education of offspring would go farther, too, because tuition charges could be held down. Federal student aid funds would buy more educational opportunities for more students.

Under this scenario, less educational debt in the aggregate would probably be necessary than in the other cases and student debt service capacity would also be greater than in the low return cases. More students would find it comfortable to pay off their student loans on a ten or fifteen year repayment plan. Worry about high levels of student indebtedness would be less of a public policy concern and also less a source of student anxiety and parental guilt feelings. Perhaps relatively few middle income students would think it worth their while to enter into an income contingency repayment plan, mainly those whose educational expenses are at the high end and who also plan to enter professions in which a high level of earnings is deferred for some years, medicine being perhaps the extreme example.

Inevitably, this scenario would also have administrative consequences for the U. S. Department of Education. A lower volume of lending would call for smaller loan service administrative capacity, and a smaller fraction of this capacity would have to be devoted to loans subject to income contingent repayment. Unpleasantly, however, a larger percentage of borrowers, and of aggregate indebtedness, might be in default-prone categories, since fewer students with average resources and prospects would borrow, and they would borrow less. Administratively, income contingent repayment plans would probably be seen more as a way to reduce defaults (and urged upon borrowers for this reason?), than as a convenience or necessity for typically successful students

But is this a likely scenario? Obviously, no one is much counting on slowing the rise of educational costs. Both public and private institutions are projecting continuing increases in tuition levels. The Congress raises student loan limits in anticipation of higher individual demand for student credit. Parents are being urged to find ways of saving more for their children's education.

On the other hand, however, there are indications that efforts to control costs are becoming more serious. Some chief executives of major universities have recently urged a new look at the structure of higher education costs, including the time it takes to get a degree. Some state coordinating boards are looking at elements of the problem. Organizations of liberal arts colleges have taken an extremely tough look at the cost structure of such institutions. The prospects for cost restraint cannot altogether be discounted.

What about the second assumption of this scenario? What are the chances of continued high returns to education? It has become a commonplace that we live increasingly in an information society. It is, however, worthwhile to try to be precise about what this means for returns to investment in higher education. The relevant considerations seem to be these: In an open world market there will be less of a premium than in the past on being an unskilled citizen of a capital rich, technology rich country . Special talents and luck aside, only those who have skills that combine highly productively with technology and capital can expect to be relatively well paid.

Many will gain such skills from going to college. However, there is no reason to think that a college degree not conferring such skills will automatically command a good income, any more than that a high school diploma that reflects few skills will do so. The only thing that will reward higher education in general with high returns is a widespread expansion of the kinds of service and managerial employment in which the baccalaureate credential serves as an aid in screening job applicants and opens doors to on-the-job training.

Unless such expansion can be predicted, there is no reason to think that the information society will make permanent the high returns to college education experienced in the l980's. It is worth remembering that expectations of such returns in the late l960's failed to materialize. It was in the l970's that the taxi driver with a degree in English became part of the folklore. It was not until the l980's that a bachelors degree once again commanded a large premium, and part of the recovered advantage was due to a real decline in the value of a high school diploma.

Thus, the assumption of Scenario One of stable or lower costs (and tuition) is not perhaps as wildly unlikely as it might appear, but the return-to-education assumption is perhaps less likely than many people seem to take for granted.

How might we expect parents to behave in this attractive world, whether it is probable or not? That is, middle class parents who are now expected to make serious sacrifices for education? Under this first scenario they would be relieved of an important amount of anxiety about being able to do enough for their children. They would not, for example, feel great pressure to sacrifice more for their children to avoid their children having to pile up daunting levels of debt.

What would they then do? They might, of course, simply decide to spend more on themselves, either currently or through accumulating assets for retirement. There are, however, other possibilities that would have implications for the educational system. If parents want their children to achieve, not just the relatively good incomes promised by this first scenario to the general run of college graduates, but really high incomes, they might decide to invest more in other phases of education--in private elementary and secondary education, in graduate education or in private baccalaureate education. They might see any or all of these as giving their offspring some kind of inside track on large success. Something like this may have happened on a considerable scale in the late l970's, also a benign period for financing college for such families. It is arguable that these would have been very good years indeed for private schools, graduate schools and private colleges, but for the impact of inflation on endowments, energy costs and faculty income expectations.

Scenario Two--High Returns to Education and Continued Rising Costs (and Tuition)

This scenario would, in effect, represent a continuation of the recent past. How likely is it? The discussion of assumptions in the preceding section suggests that the assumption of continuing rising costs is all too plausible, although there just might be help on the way. The validity of the high returns assumption of this scenario depends mainly, as noted, upon labor market conditions. But it should also be noted that there is a least some tendency for these conditions to feed on themselves: To the extent that high tuition, net of subsidies, reduces the number of college graduates, returns to education will tend to be maintained.

It is relatively easy to describe the motivations of the various parties to higher education finance under this scenario, since these motivations would be those of the present: Those colleges that can see their way to recovering higher costs, either from tuition charges or state subsidies, would find plenty of good things to spend additional money on, improving their products and enhancing their competitive positions. State legislatures would resist strenuously paying for these good things out of tax funds, absent great changes in the mood and preferences of the electorate. This resistance would leave continuing tuition increases in excess of the rate of inflation to take up the slack, presumably at both public and private institutions.

Who would bear the real burden of these increases, parents or offspring? Given the assumption of continuing high returns to a college education, both of these parties would often be willing to pay, for added costs could still leave higher education a good investment. Managing these costs without crippling either students or parents would often seem to be more of a problem than their amount.

This, of course, is part of the situation to which the Direct Loan Program is responsive. Both longer repayment periods and income contingent repayment plans make it easier to handle larger amounts of student debt. The student borrower will often have to wait longer before he can "burn the mortgage" on his education--possibly, not until his children are in college--but his later installments will be paid out of a larger income, if he follows a typical earnings trajectory under this scenario.

We should be aware, however, that precisely these advantages of the new program materially bias the financing system in the direction of student credit financing and against parent financing. Students, not parents, will have the new options. Arguably, Scenario Two contains an inherent bias in favor of student rather than parent financing: If, indeed, returns on investment in college are predicted to be high, and if public and institutional policy endorse this prediction, then who is to say that students themselves should not pay for it? After all, they will be earning the corresponding high incomes.

Thus, although this is by no means the least attractive of the four scenarios, it would make even more conspicuous some troubling features of the financing system of recent years. The shift of burdens from the parent and taxpayer generations to the student generation would be ever more pronounced. Further, students who are ineligible for grants and other subsidies because of their parents' incomes will be paying the added costs, not those parents whose incomes made them ineligible in the first place. Subsidized and unsubsidized students might see little difference in their futures, but much difference in the way they must finance their educations. It is a recipe for a variety of resentments.

However, this unattractive picture is not necessarily an apocalyptic one. Since the late l970's the trend has been for students themselves to pay an ever larger share of higher education costs. Some would see the direct loan program as aiding and abetting that trend, to the point where students would be expected to bear the whole burden, through income contingent repayment plans or their own in-school earnings. It seems more likely, however, that many--or even most--parents would continue to try to do what they feel they can. But they would often be unhappy about how little, as a share, this turned out to be, and so would their offspring.

To deflect at least some of the bias against parent and in favor of student financing, it might be worth thinking seriously about a plan for loans to parents that has at least some of the merits of an income contingency scheme. One such idea would be a loan to parents that would be repaid after graduation in installments (over ten years?) equal to the parental contribution that would be expected if the student were continuing in college. This option would be helpful to some parents, if not all, in continuing to meet a traditional share of the financial burden.

Another idea worth considering is what might be termed a "higher education strip". It has been suggested that it might be helpful administratively to separate collection of loan principal from the collection of interest in the servicing of income contingent loans. Elaborating on this notion, a hybrid loan might be devised on which parents would owe payments of interest, and offspring would owe repayments of principal. A socially valuable mutuality of responsibility might result, institutionalizing the kind of informal obligation parents have often assumed in the past regarding their children's student loans.

Administratively, this scenario would probably lead to the greatest amount of aggregate educational credit of any of the four scenarios. It assumes that higher education will be both very desirable and very expensive. Student loans, readily available through direct lending, would be the resource readily available for the financing. In comparison, the other three scenarios would make higher education either cheaper, or less desirable, or both, with a lower level of aggregate demand for loans.

Scenario Three--Low Returns to Education and Stable or Lower Costs (and Tuition)

This scenario is predicated on conditions much current thinking about higher education finance largely ignores: much better restraint on costs coupled with low returns to higher education per se.

It is clear that constant dollar resources would go farther in a world where costs rise at less than the rate of inflation. This would be true of state, Federal and parental resources and also of student earnings. But if expectations of high returns from college were brought up short, the willingness of all these parties to invest in higher education might still diminish. The exception might be forms of post secondary education that impart professional or technical skills that give those who acquire them a demonstrable edge in the job market. The careerism that is already the bane of traditional liberal arts education might well increase.

The situation of parents under Scenario Three would be puzzling. On the one hand, higher education would be relatively less expensive. On the other hand, except for higher education in its more occupational forms, it might still seem a luxury.

A phenomenon already affecting some families might become much more widespread, and might even dominate public perceptions of higher education: the phenomenon of having to finance four or more years of baccalaureate education, and then one or several years more for the acquisition of marketable skills. In this situation, higher education would not look cheap at all, even if costs and tuition levels were well under control.

However, this scenario does have a silver lining. Colleges, constrained to control costs, would also be constrained to demonstrate value and effectiveness, by standards that the students they want to recruit, and the parents of those students, would recognize. Among other things, they would seek to demonstrate that their graduates are ready for real, existent, jobs. Higher education would be, and be seen to be, more central to the functioning of our society and more socially responsible than many now regard it.

In the world envisioned by this scenario the most important feature of the direct loan program might well not be the income contingency option or even higher loan limits such as those enacted in 1992. It might instead be that the position of the individual college in the initiation of loans would be most important. The program puts colleges in a position to present students and their parents with a fully individualized financial plan consistent with a demonstrably efficient educational program, laying out costs and benefits realistically and competitively. The enhanced aid packaging flexibility inherent in the direct loan program would make this possible.

Administratively, one would expect a lower aggregate level of student lending under this scenario than if costs were rising or returns to education were high. It could well be, however, that, compared to any of the other three scenarios, a larger percentage of students who did borrow would choose an income contingent repayment plan, because of their less optimistic income prospects.

Scenario Four--Low Returns to Education and Continued Rising Costs (and Tuition)

This is the nightmare scenario: continued rising costs and low rates of return. Here, silver linings are hard to find. About the only people who would be comfortable under these conditions would be those who would be happy with a degree of elitism in higher education we have not known since the l930's. Only those whose family resources or special talents would eliminate anxiety about labor market competition might have much interest in liberal arts education in any of its traditional forms. The rest might feel that only clear occupational advantage justified the financial sacrifices entailed by education beyond high school.

Is this scenario likely? Perhaps not, but it is not impossible either. To envision what these conditions would be like, in mild form, it is only necessary to imagine the tuition increases of the l980's coupled with the labor market of the l970's. There would be great anxiety about both the worth and the affordability of college. Students who wanted to go ahead anyway, despite the circumstances envisioned, would face the likelihood of large amounts of debt which only an extended or income contingent repayment scheme could make tolerable. There would often be only four choices: no college, a protracted time in college (permitting greater amounts of student earnings), appalling parental sacrifice, or income contingent loans.

This very unattractive picture serves to highlight an aspect of the Direct Loan Program not usually made explicit: It can be viewed as a kind of insurance against a serious crisis in higher education finance. Its extended and income contingent repayment features would give students and their parents a very valuable recourse in bad times.

But even if income contingent repayment made large amounts of student debt manageable, former students would often find that they had little debt service capacity left over to finance purchases of cars or housing, at least for many years. It is difficult not to expect that a good many academically capable young people would forego college altogether or would enter only the most short term and occupationally oriented programs. This likely result would make it possible to construct a powerful case for a return to public policies of greater emphasis on institutional subsidies (by the states) and greater emphasis on grants over loans (on the part of the Federal government).

Under this scenario, the government's credit could be committed for very long periods and cumulatively in very large amounts, even if annual loan volume was modest. No mutualization of risk is contemplated by the Direct Loan Program repayment plans, but a phenomenon akin to adverse selection would occur: A much larger proportion of borrowers would be likely to chose an income contingent plan than under any of the other scenarios, and their loans would remain on the books for a very long time.

General Observations

Can we generalize from the preceding speculations? Perhaps a few general observations can be made:

1. The direct lending program seems unlikely to change the fundamental circumstances of higher education finance, except by making it easier for students to borrow, and repay, a larger share of costs and for colleges to plan and implement their own packaging policies.
   
2. In certain circumstances, one of these two features of the program could turn out to be the most important one, in other circumstances the other.
   
3. Better restraint of real costs holds out the best hope of avoiding a further shift of financial burdens to families and, within families, to children.
   
4. Absent such restraint, the direct loan program can help limit damage and alleviate (not eliminate) painful adjustments.
   
5. A lower rate of return to investment in higher education in general would pose serious educational and financial challenges to institutions of post secondary education, even as an income contingent repayment plan would help them, and the students they enroll, to cope with those challenges.
   
6. The kinds of financial and work-load projections the Department will have to make from year to year could be extremely tricky. A set of assumptions that would be perfectly reasonable under one scenario could, if costs or returns changed direction, turn out to be wrong--that is, if conditions changed to those of one of the other other three scenarios.
   

For more information please write the Planning and Evaluation Service, Office of the Under Secretary, U.S. Department of Education, 400 Maryland Avenue, S.W., Room 3127, Washington, DC 20202-8240.

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