How Student Loan Refinancing Could Undo Federal Loan Policy

January 26th, 2016 / By Kyle McEntee

Originally published on Above the Law.

If you’re a law school graduate with a ton of debt, there are a few companies that really want to talk to you — if you went to the right school and have the right job.

The deal works like this. The bank or non-bank lender pays the federal government the balance of your loan and you pay the new lender instead. In exchange, the private lender charges you a much lower interest rate. Rather than a rate north of 7%, you receive a rate as low as 2.5%.

The lender wins because it collects your interest payments. You win because you pay a lower interest rate. The federal government immediately loses. When you refinance, it collects no interest.

Before 2010, private lenders issued student loans guaranteed by the government. If you didn’t pay, the lender got paid anyhow. In 2010, Congress decided to stop allowing banks to socialize losses from unpaid loans. By directly lending to students through the Department of Education, taxpayers still covered the losses, but interest would be paid to the government and cover some or all of the losses.

In theory, interest rates reflect the repayment and other risks associated with the lender’s initial cash outlay — whether the lender is a private company or the government. A lender that refinances your student loan says that your rate is too high and that it can profit from offering you a lower rate.

But private lender refinancers are choosy. To qualify, you usually need the right education, job, and credit. In other words, they look at your particular risk profile. If you work for a large firm and went to an elite law school, they feel pretty good about getting their money back, so they are willing to slash your rate by more than half.

Interest rates for direct student loans issued by the government are set differently. There are no underwriting standards and the rates are uniform each year.

This is not entirely crazy. For all of its design flaws, the purpose of our federal loan system is to provide access to education for those who cannot otherwise afford it. If you are a first-generation college graduate from a low-income family, have no assets to secure a loan, and no credit history, you would pay a double-digit interest rate if you could get a loan at all.

By charging a uniform rate, the low-risk borrowers subsidize the high-risk borrowers. Rather than some borrowers paying 15%, some paying 2.5%, and others not being able to borrow at all, everyone pays the same rates: 5.84% on Stafford loans and 6.84% on Grad Plus loans issued this year. Law students can borrow as much as their school says it costs to attend, which is how the cost of attendance at some schools is almost $90,000 per year and still increasing well above inflation.

It’s good for our economy and for our society to allocate resources in this way when all goes to plan. But what happens when schools explode prices, the job market is soft, wages stagnate, and tens of thousands (or more) of graduates need to rely on income-based repayment programs to meet basic human needs? A policy mess.

Private lenders cherry pick low-risk borrowers after they’re much easier to identify. They monetize the spread between these borrowers and their high-risk peers. When the government finally figures out that it needs to peel back the layers of its lending initiatives at a program-level, it will see an exodus of the people supposed to pay for its well-intentioned policy. Taxpayers will be left holding the bag once masses of graduates have their loan balances forgiven. After all, income-based repayment makes wage garnishment a thing of the past.

It’s eerily like retail mortgage-backed securities, which had AAA ratings until they didn’t.

It is worth noting that the student loan interest rates set by the government are arbitrary. Unlike a private lender that takes tremendous care in setting its interest rates, federal student loan interest rates reflect political will and bargaining. Those same tidal forces may swiftly eliminate the parts of federal student loan policy that are keeping law schools’ broken economic models from crashing.

I feel like a broken record, but law schools need to get their acts together and lower prices substantially. Law schools are not alone — about half of Grad Plus loan balances are in income-based repayment programs — but they are easy targets for a myriad of legitimate and illegitimate reasons.

If done right, reconfiguring the student loan program for law schools could greatly benefit students, our profession, and society. Done wrong, it could screw up even more lives and jeopardize the rule of law. At law schools alone, the government originates between $4 and $5 billion of direct student loans each year. Politicians would love to spend $50 billion over 10 years in other ways.

Law schools can wait to see what happens. Or they could do what they should do and self-regulate, as members of a profession ought to do.