Subprime Private Student Loans: No Way Out

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Although private loans make up a relatively small slice of the roughly $1 trillion in outstanding student debt, a new report from the Consumer Financial Protection Bureau in conjunction with the Department of Education shows that these loans have the ability to harm borrowers’ credit and future financial security at a disproportionately high rate. 

A $5 billion industry just over a decade ago, the private student-lending market ballooned to four times that size before the economic crisis hit. It shrank back to $6 billion last year, but that contraction still leaves a huge number of students and former students saddled with debt they can’t afford to repay. It’s gotten so bad that government officials are calling on Congress to permit private student loans to be wiped out in bankruptcy.

How did we get to the point where even some people in government are suggesting bankruptcy as a fix-it?

As with subprime mortgages, private student loans were handed out to people who could never realistically be expected to repay them, then bundled into securities for which there was a seemingly endless appetite. In the run-up to the financial crisis, lenders went out seeking increasingly high-risk borrowers to meet this demand.

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For-profit colleges fed into the demand: during the 2007–08 academic year, nearly half the students at four-year, for-profit schools had private student loans. These schools need private loans to augment the federal student aid they accept, so their top priority was getting students to borrow as much as possible — whether or not they needed it. The dismal rate of employment for graduates at many of these schools compounds the problem. Former students are stuck with a slew of loans they might not have needed, and a degree that’s worth little.

It gets worse. The key difference between the student-loan debt bubble and the mortgage meltdown is that if a person who never should have qualified for a mortgage defaults, the lender — or the investors who buy securities full of the loans that went bad — is the one who loses money. Homes can be foreclosed on, and consumers can declare bankruptcy. This element of risk is supposed to be what motivates lenders and the investors who buy securities to be diligent in their underwriting and risk assessment. Student loans, on the other hand, can’t be discharged in bankruptcy. With few exceptions, the borrower is stuck with the bill until he or she pays it off.

That leaves lenders with less incentive to make sure they’re lending to qualified borrowers. It’s true that many were burned by defaults after 2008, which is why roughly 90% of private loans now require a co-signer and why the market contracted so severely. The other reason for the market shrinkage is that, after 2008, investors no longer wanted to buy what they realized were financial time bombs, and lenders certainly didn’t want to keep them on their books.

(MORE: From Insult to Injury: Rise in People with Student-Loan Debt — and No College Degree)

These loans are also time bombs for the borrowers who are saddled with them, according to the report. “The [private student loan] was designed to mimic a Stafford [federal] loan during school, but it has key differences which create risks for consumers if the future path of interest rates, the economy, and the labor market vary beyond initial expectations,” the report says.

Many students and their families don’t understand the difference between federal and private loans and unwittingly get locked in to private loans that have much less favorable terms, even if they’re eligible for federal aid. Federal student loans have fixed rates and don’t require borrowers to meet creditworthiness standards, while private ones tend to offer variable rates and use borrowers’ credit to determine the rate they’ll receive, which can be as high as about 20%.

There are also critical differences when it comes to repayment. Federal loans are more lenient and provide low-income or unemployed graduates with options, while private lenders offer, at most, short-term forbearance. Defaulting on a private student loan can happen much more quickly — it takes only120 days of nonpayment, a short time frame in an economy in which many people are out of work for months. In 2009, the unemployment rate for people with private student loans was over 16%.

(MORE: Is Forgiving Student-Loan Debt a Good Idea?)

The debt burden can be crushing: in 2009, 5% of all students who took out private student loans and 10% of students who took out those loans and earned a bachelor’s degree owed more than 25% of their monthly income. This is why the report calls on Congress to step in and craft legislation that would permit debt-laden people to discharge private student loans in bankruptcy.

It also recommends other consumer protections and oversights to keep the next generation of college students from falling into the trap of private student-loan debt in the first place. But altering the bankruptcy code would be the action that would give current borrowers the best shot at relief. In fact, the report says some people are choosing to declare bankruptcy so they can ditch their other debts in order to pay off that immovable student-loan debt.

“Consumers, as well as businesses, have been able to restructure other types of debts through bankruptcy as a last resort,” the report points out. It asks Congress “to consider modifying the code in light of the impact on young borrowers in challenging labor market conditions.”

MORE: What to Do if You Can’t Pay Your Student Loans

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