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Here's Why the Student Loan Market Is Completely Insane

Harvard University
Harvard UniversityPhotograph by Brent Lewin/Bloomberg

President Obama made news this week by expanding a student loan program to broaden the eligibility of borrowers and proposing to limit monthly payments to 10 percent of a student borrower’s income. On the margin, such moves might help. But the administration’s efforts don’t address a more fundamental problem: These loans aren’t calibrated for risk. In other words, students from Harvard and less-prestigious regional colleges are thrown in the same bucket, despite quite different risk profiles.

Under Federal Deposit Insurance Corporation (FDIC) rules governing the insurance of banks, lenders can’t differentiate among schools in assessing credit risk as they do with home buyers and car owners. As a result, “the government has made it difficult for banks to price to default rates,” says Mike Cagney, founder of Social Finance, a socially based student lending operation known informally as SoFi. “By accepting FDIC insurance, banks lose pricing flexibility and can’t charge interest rates commensurate with the quality of schools—and default rates vary widely by schools.”