Most financial aid professionals recommend federal student loans because these loans are cheaper, more available and have better repayment terms. But, federal student loans also share many characteristics in common with predatory loans. So, let’s consider the question: Is the federal government a predatory lender?
A predatory lender makes loans with unfair or abusive terms and conditions, where the lender coerces, induces or deceives the borrower into accepting the loan. A predatory lender may also take advantage of a borrower’s lack of understanding and lack of sophistication with regard to complicated financial transactions.
The U.S. Department of Education makes loans without regard to the borrower’s future ability to repay the debt. Perkins and Direct Subsidized and Unsubsidized Loans, for example, do not consider the student’s credit history. Aggregate loan limits are not based on the student’s likely income after graduation.
While eligibility for PLUS Loans does depend on past signs of financial difficulty in the borrower’s credit history, eligibility does not depend on evidence of the borrower’s future ability to repay the debt, such as credit scores or debt-to-income ratios. The PLUS Loan bases annual loan limits on the college’s cost of attendance and not on the student’s projected future ability to repay the debt or the parent’s current ability to repay the debt. The PLUS Loan does not have any cumulative loan limits. More than 10% of Parent PLUS Loan borrowers are clearly incapable of repaying the loans based on the parent’s current adjusted gross income. More than 15% of Parent PLUS Loans are borrowed by parents of students who receive the maximum Federal Pell Grant.
Colleges are not permitted to categorically reduce loan limits based on the borrower’s degree level, academic major or enrollment status. For example, students who are enrolled on a half-time basis can borrow the same amount as full-time students. The U.S. Department of Education has issued guidance that restricts the colleges’ statutory authority to reduce loan amounts, thereby, preventing colleges from taking steps to ensure that students graduate with an affordable amount of debt.
The defense of infancy does not apply to federal student loans, allowing the U.S. Department of Education to lend to inexperienced borrowers who are too young to open a bank account or get a credit card on their own.
While the lax credit underwriting criteria on federal education loans may help more students and parents qualify for loans, it also means that some borrowers are accepting loans that they cannot afford to repay.
Policymakers often argue that easy access to federal loans provides low-income students with access to a postsecondary education. But, loans are not really financial aid, as they don’t cut college costs. Loans must be repaid, usually with interest. Loans are not a solution if they bury borrowers in more debt than they can afford to repay.
Something is deeply wrong with the current federal student aid system when Federal Pell Grant recipients are about twice as likely to graduate with debt as non-recipients, and with thousands of dollars of additional debt. Federal student aid policy should be based on a principle of meeting the demonstrated financial need of low-income students solely with grants, not loans.
Federal student loans are not subject to the Truth in Lending Act (TILA), so there are better disclosures about the costs of private student loans than federal student loans. Private lenders must provide an Annual Percentage Rate (APR) and give a student three chances to confirm that they want to take out a private loan. Federal loans have no such requirements.
The U.S. Department of Education also does not educate borrowers about the risks of borrowing too much money, nor does it provide them with robust, personalized financial literacy training. Borrowers may lack the skills, insights and information they need to make informed decisions about student loan debt.
Interest is charged on unsubsidized federal student loans during the in-school period and on all federal education loans during forbearance periods. If the borrower does not pay this interest as it is charged, it is added to the loan balance (capitalized). This causes the loan balance to increase and interest to be charged on interest, yielding a bigger and more expensive loan.
The U.S. Department of Education practices discriminatory pricing, charging graduate and professional students higher interest rates than undergraduate students, even though graduate and professional students have lower default rates. Such discriminatory markups on loans to graduate and professional students may result in hundreds of millions of dollars in consumer harm through increased interest charges each year. The U.S. Department of Education also varies loan limits by the borrower’s year in school, offering lower loan limits to college freshmen and sophomores than to upperclassmen, despite bans on age discrimination.
Federal student loans have high default rates, with more than 10 percent of borrowers defaulting on their loans within three years of entering repayment. Lifetime default rates may be as much as double the short-term cohort default rates. The U.S. Department of Education continues to lend to students at a college until the college’s cohort default rate exceeds 30 percent a year for three consecutive years or 40 percent in any single year.
While income-based repayment (IBR) and pay-as-you-earn repayment (PAYE) are intended to provide a safety net for borrowers who are struggling to repay their loans, they also share many characteristics in common with predatory loans. For example, federal education loans may be negatively amortized under IBR and PAYER, increasing the size of their debt. The debt may be forgiven after 20 or 25 years in repayment, but the forgiven debt is treated as taxable income to the borrower, replacing student loan debt with tax debt. The tax debt functions like a balloon payment, unless the borrower is able to negotiate a payment plan with the Internal Revenue Service (IRS). When the student loans aren’t negatively amortized, IBR and PAYE stretch out the term of the loan, forcing borrowers to pay more interest than they would under a standard 10-year repayment term. The U.S. Department of Education encourages borrowers to choose these income-dependent repayment plans, even when the borrowers are capable of paying more. The U.S. Department of Education has proposed regulatory changes, as part of the Revised Pay-As-You-Earn Repayment (REPAYE) plan, which would restore a marriage penalty that is more severe than the one imposed by federal income taxes.
Federal student loans are discharged when the borrower dies or becomes totally and permanently disabled, but the cancelled debt is treated as taxable income. So, the federal government tries to tax the loan forgiveness provided to disabled borrowers, grieving parent borrowers and financially struggling borrowers. The government gives with one hand and takes back with the other.
Of course, nobody forces students and parents to borrow from the federal education loan programs. But, they may not have many other options for paying for college. Government grants have been decreasing on an inflation-adjusted, per-student basis for decades, shifting more of the burden of paying for college onto students and their families, even though the federal government benefits from the higher federal income taxes paid by college graduates. This forces families to borrow, even for low-cost colleges. The federal government has held a de facto monopoly on student debt for decades, accounting for more than 85 percent of outstanding education loan debt.
While federal education loans are made without collateral, the federal government has very strong powers to compel repayment. The federal government can garnish up to 15 percent of disposable earnings, intercept federal and state income tax refunds and offset up to 15 percent of Social Security retirement benefits, all without a court order. (Borrowers do have an opportunity for an administrative hearing before a wage garnishment order is issued, but these hearings are often rubber-stamp processes, lacking even the illusion of fairness that comes with mandatory arbitration.) The federal government can block renewal of professional licenses and, in some states, driver’s licenses, preventing defaulted borrowers from earning a living. Collection charges are up to 25% on Federal Stafford and PLUS loans and up to 40% on Federal Perkins loans. The federal government is not subject to the Fair Debt Collection Practices Act.
This indentured servitude does not end when the borrower reaches retirement age. Instead, the demand for repayment continues, and the federal government can seize part of the borrower’s retirement security, oftentimes, forcing elderly borrowers into poverty. (Although the Debt Collection Improvement Act of 1996 [P.L. 104-134] does not allow the government offset for defaulted borrowers to reduce a borrower’s monthly Social Security retirement benefits below $750, this safety net falls below the poverty line and has not been adjusted for inflation since it was enacted. About half of Social Security retirement benefit recipients would be pushed below the poverty line, if their benefits are reduced by 15% to repay defaulted federal education loan debt.) Federal student loans are not subject to a statute of limitations. It is also almost impossible to discharge federal student loans in bankruptcy.
It is no wonder that the federal government is able to recover more than a dollar for every dollar of defaulted federal education loans, on average, and 80-85 cents on the dollar after subtracting collection charges.
For some defaulted borrowers, the federal government may even profit from the default, because collection charges slow the progress in paying down the loan balance, thereby significantly increasing the total interest paid to the federal government over the life of the loan. For example, a defaulted borrower with $35,000 in student loan debt at 6% interest will take 13.8 years instead of 10 years to repay the debt and will pay nearly $5,000 more in total interest, when a fifth of each $388.57 monthly loan payment is deducted for collection charges.
The federal student loan system seems set up to exploit the misery of low-income borrowers.
If private lenders were to offer loans with terms like the federal government, the Consumer Financial Protection Bureau (CFPB) might accuse them of being predatory lenders. In February 2014, CFPB Director Richard Cordray said, “we will be vigilant about protecting students against predatory lending tactics.” But, the CFPB’s vigilance does not protect students from predatory lending tactics perpetrated by the federal government. The CFPB does not have oversight over the U.S. Department of Education’s Federal Direct Loan program, and the terms of federal education loans are set by law.
Unfortunately, the Golden Rule applies to federal student loans: whoever has the gold makes the rules.
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