There is increasing talk across the political spectrum of reforming the UK’s student loan system. To the extent that the discussion has been spurred by Jeremy Corbyn’s expensive, regressive and distortionary promise to abolish tuition fees, there is reason to be pessimistic. We are likely to end up with a student finance scheme which is costlier than the present one and introduces further incentives for young people to take courses that do not benefit them.
There is, however, no question that the existing system of income-contingent loans is far from optimal. It burdens graduates with onerous debts which are uncorrelated with the market value of their education. And it leads to a large share of the funds lent out being written off after 30 years, because many graduates never earn enough to pay their loans back in full.
A number of analysts have put forward proposals to turn the student loan scheme into a “graduate tax”. This is how the present system works in practice, since repayment is not linked to the amount borrowed but rather to the graduate’s salary. However, a graduate tax would dispense with the fiction that the amount borrowed matters in any meaningful way.
Martin Lewis from MoneySavingExpert.com explains it succinctly: if you owe £30,000 and earn £25,000 a year, you repay 9 per cent of everything above the threshold of £21,000, that is, £360 every fiscal year; if you owe £2bn and earn £25,000, you repay 9 per cent of everything above £21,000, that is, £360. The outstanding loan amount does not matter for repayment. And because whatever remaining balance is cancelled after 30 years, there is no incentive to restructure student debt or to constrain the amount borrowed for.
If the graduate tax were decentralised to universities so that they could compete to offer students competitive rates and an education which they could effectively monetise on the market after graduation, all the better. This is the reform proposed by Peter Ainsworth in a 2014 paper for the IEA.
There is, however, one aspect of the discussion where thinking is deeply muddled. That issue is the interest rate that students should face. The conventional argument runs that interest as charged at present is abusive and unfair, making students feel that their debt burden is escalating whilst their wages stagnate through no fault of their own.
Whether made on ethical (“interest is usurious”) or pragmatic grounds (“interest makes student debt insurmountable”), the consensus appears to be that interest rates need to be lower than at present, if not to be dispensed with altogether. Some have argued that the only annual increase in headline debt loads should come from inflation adjustments.
What these arguments miss is that loan interest is a price, and a price is a signal. What do interest rates signal? Firstly, the lender’s willingness to part with their money for some time, that is, the compensation they will require for postponing consumption. Secondly, they signal the risk associated with the activity for which the money is borrowed. Borrowing with collateral carries a lower interest rate, since the lender has some security that at least part of the funds will be recovered. A lower likelihood of repayment obviously carries a higher interest rate.
Now, consider the market for student loans. There is no collateral since a student’s future earnings cannot be coerced: slavery is illegal. The likelihood of repayment varies widely among individual students and, more practically, among degrees. The inference has to be that lending to students is a risky proposition in general, and that borrower risk varies widely among borrowers.
Seen in this light, a nominal annual interest rate of 6.1 per cent, assuming inflation at 2 per cent which is the Bank of England’s target, is not high at all. Compare it to rates on unauthorised overdrafts and credit card debt often in excess of 20 per cent, and student loan interest looks positively charitable, considering that the other forms of consumer debt are also not collateralised but don’t magically expire after 30 years like student loans do.
What is more surprising is the uniformity of rates charged to all students. In a free market, £20,000 borrowed to study finance would carry a lower interest rate than the same amount borrowed for a philosophy degree, simply because the likelihood that the former student will pay back, and pay back in full, is higher.
It may seem like we’re doing the philosopher a favour by charging him interest at the same rate as the finance student. But we’re doing nothing of the sort. The low interest rate is a signal to the philosopher that it is a good idea to borrow and spend time pursuing a philosophy degree, when in fact the real cost of his education will never be justified by his earnings post-graduation. We promise him partial amnesty in 30 years’ time, when taxpayers will shoulder the burden instead. But that is little consolation to someone who, facing the true cost of his borrowing, might well have made different choices.
The present system of student loans is unfair, regressive and inefficient. But interest rates are not at fault. They are, in fact, one of the tools through which the crisis in higher education funding can be tackled.