Will Private Lenders Fill the Loan Limit Gap?

Private lenders have played a relatively small role in financing higher education over the last 20 years, but that’s about to change.

In Delaware, state leaders have invested $800,000 in an unconventional student lending start-up, a local news outlet reported. Meanwhile, many universities have named established companies as the preferred lenders for their students. And some colleges are developing their own lending programs—all to help close funding gaps created by new limits to federal graduate student loans, which go into effect July 1.

It suggests something of a return to earlier times, when private lenders served as the predominant source of funding for graduate education. That changed in 2006, when Congress introduced Grad PLUS—a federal loan program that covered up to the full cost of attendance at any given institution.

Now Grad PLUS is no more. Instead, a new loan cap will take effect next week, limiting students to $20,500 or $50,000 a year, depending on their program. That means either colleges will need to lower their costs, or students will be forced to turn to private lenders with higher interest rates to make up the difference.

The problem is that not all students in need of private loans will be able to access them. Republican lawmakers who crafted the loan limit stressed that private lenders would largely make up the difference. But unlike federal loans, which are largely open to borrowers regardless of their credit history, bank loans rely on strict underwriting policies to assess risk and determine who will most likely pay them back. That means students with poor or no credit history will be shut out of the lending market.

“Congress is seeing this as a one-to-one transition, where if people can’t get guaranteed federal aid, they’re going to easily be able to tap the private student loan market,” said Bonnie Latreille, co-founder of Protect Borrowers, a leading student loan advocacy group. “What we see is that, actually, when people have to rely on private student loans, they either get way more expensive loans or they can’t get loans at all.”

At current tuition prices, at least a quarter of all postbaccalaureate students will need private loans or some other means to pay for their education. But of those students, nearly four in 10 have either subprime credit scores (below 670) or have no credit history at all, according to research from the Postsecondary Education and Economics Research Center at American University. So unless they can find a family member with a stronger repayment history to serve as co-signer, many of those students’ loan applications will be denied.

Some conservative policy experts and loan servicers, however, say this gap in access is intentional—designed to correct years of skyrocketing debt by ensuring loans only go to students likely to pay them back. They also note that in addition to banks, other actors—including state governments, employers and universities themselves—can step in as part of the solution.

“[Private lenders] will absolutely not replace all of the loan volume … and that’s actually a good thing in my perspective,” said Beth Akers, a senior fellow at the American Enterprise Institute, a right-leaning think tank. “Lenders don’t want to give loans to people that aren’t likely to be able to repay, and students don’t really want to take on loans that are unaffordable for them.”

Last-Ditch Option

Intentional or not, leaving tens of thousands of students without the ability to borrow will have far-reaching consequences, liberal policy experts and student borrowing advocates say.

First-generation and low-income students who previously used Grad PLUS to earn high-demand degrees, secure well-paying jobs and pay back their loans may not be able to pursue grad school, especially since private lenders tend to look back at an individual’s repayment history rather than forward at the earnings potential of their degree. In the long run, experts agree, this could mean that fewer students enroll in master’s or doctoral programs, and some programs may be forced to close. But some students could be pressured into stopping out with some debt and no degree, or finding a more expensive, higher-interest loan as an alternative to cover the cost of tuition.

For example, the Delaware-funded start-up GradBridge is designed to assist students who narrowly missed the eligibility mark for traditional loan servicers. In particular, it’s marketed as a tool to help students who are already enrolled but have reached the loan limit, making them unable to finance their last few credit hours. However, the loan comes with an interest rate of 18 to 23 percent. (Most private student loans charge an interest rate of between 3 and 17 percent, data from The Wall Street Journal shows.)

Jennifer O’Donald, GradBridge’s CEO, acknowledged in an interview with Inside Higher Ed that students should use every other option they have, such as state and institutional grants, private scholarships, and federal loans, before turning to a company like hers. But even if the interest rate is high, O’Donald said, the existence of a lender like GradBridge to support low-credit students is better than the alternative.

“It’s going to take everyone to help students understand their options, solve their funding gaps and prevent those gaps from becoming the reason why they’re not graduating,” she said. “So while our rates are higher to account for the additional risk of the borrower, we believe that having this loan option can be the difference between them staying enrolled and dropping out.”

Student advocates, however, say it shouldn’t be the borrower who bears the burden of the new loan limits, taking on more costly loans in order to pursue grad school as a platform for socioeconomic mobility.

“Yes, we should absolutely be policing schools about [the cost of education and] the ability to repay,” Latreille said. “But until we solve systemic disparities in financial markets, it is unfair to try to force a market correction” in a way that impacts individuals.

The Value Proposition

Still, defenders of the loan limits say the return to private lenders doesn’t have to come at the cost of college access. Not all programs cost more than the federal loan limit, said Scott Buchanan, executive director of the Student Loan Servicing Alliance, an association that represents the companies managing and collecting student loans.

A new cost-comparison tool designed by Leadership Brainery, a college access nonprofit, using existing data from the Department of Education, shows that 9,754 of the 13,594 programs analyzed (or more than 70 percent) fall below their respective loan limits.

Buchanan hopes that being denied loans will simply force students to “shop smarter.”

“I’m sure everyone in the world would love to drive a Maserati, but we live in the land of reality, which is, if the car is to get you to work, you find the most valuable car for your budget, and I think that’s what students and families are going to need to do” when it comes to college degrees, he said.

Buchanan and others also noted that while current loan regulations deter the consideration of group-based factors in underwriting—like what program a student is enrolling in, the outcomes of its graduates or the rate at which they pay back their loans—that could change.

Currently, guardrails put in place to prevent lenders from denying people loans based on race heavily limit lenders to considering agnostic characteristics like past payment histories. That’s where the backward-looking model comes from. However, if regulators can find a way to continue preventing discrimination while also allowing more nuanced, forward-looking group assessments like graduation rates, average earnings and repayment patterns in higher ed, lenders would likely adjust their standards and the number of students with private loan access could grow, experts explained.

But first the policies need to change.

“Regulators really need to give us more firm guidance about what additional factors we can look at, because lenders are not going to step out into the gray and hope it all works out,” Buchanan said. “We want to walk before we run.”