Student Loans: The good the bad and the Ugly

National announced yesterday that it is going to keep interest free student loans. As someone with a student loan I love the scheme and the free money it gives me. When I put my economist hat I think that it is terrible policy since it provides terrible incentives to for students to borrow. I personally didn’t have a student loan until they became interest free at which point I borrowed as much money as I possibly could.

Not only are National not avoiding electoral suicide by alienating students, they have also said they will provide a 10% bonus on early payments of more than $500 to help combat the fact that students have no incentive to pay back their loan while they are still in New Zealand (0% nominal rate=negative real rate due to inflation, i.e. your debt shrinks over time, isn’t that cool?).

Now this sounds nice on the face of it, but David Farrar has put on economist hat and worked out that while this improved incentives for repayment, it exasperates the perverse incentives regarding borrowing. DPF notes that an optimal strategy for a student would be to borrow as much as you could and then pay it off at the end of the year giving you a nice 10% return for your effort. However the problem is actually worse than that. If we take into account what can be done with the money in the mean time, the problem is actually much worse.

To illustrate let’s look at a student who needs to use the maximum $150 living costs, but like many students uses the maximum $1000 course related to costs to guy buy fancy clothes or booze. Simplifying things greatly because I can’t be bothered doing a spread sheet, If he gets the $1000, put’s it in a rabo term deposit and earns 8.7% interest he has $1087, but he only owes $900 if he pays it off straight away, giving him a nice $187 profit, or a 20% return for a years work. This is a very simple example, but you can imagine how the maths gets rosier once you do it properly and extend it beyond one year and get some compound interest going, add in the $1000 you can borrow each year and add some living expenses if people can spare and the case for maximum borrowing grows. Repeating that exercise for 4 years is probably better than you could do on the stock market and it is entirely risk free, gotta love arbitrage!

The big question then is, will this actually make things worse? What it really comes down to is how strongly students have responded to the existing bad incentives to borrow. I know I borrowed the maximum I could as most economics students would so I couldn’t borrow anymore. If the majority of students think like I do then they can’t borrow anymore so this policy will be better than the status quo as debt will be paid off quicker. If students didn’t respond to the introduction of interest free student loans as strongly as I did, then it is possible that the benefit of increased repayment will be offset by the increased incentive to borrow. Then again, people who didn’t respond strongly to interest free loans being introduced probably won’t respond to this either….. (I’ve always found it interesting that arts and social sciences students claim not to be motivated by by money yet they are the ones who spend so much time protesting University fees, go figure).

Ultimately, it’s going to be an empirical matter of whether borrowing will increase as a result of this policy, if it doesn’t then great, if it does then the policy could have a positive or negative effect. Presumably it can’t be that hard to find whether students are borrowing the maximum level or not as student loans are all done electronically these days. It definitely warrants further investigation before it’s implimented.

More serious than usual

Agnitio

  • limitedfaith

    I’m pretty sure that you’re analysis is flawed.

    Firstly, the real rate on student loans IS 0% as far as I’m aware – they are inflation adjusted. Aren’t they?

    Secondly, extend your example a bit further and I think you’ll find that the best outcome for the student is to never make a voluntary repayment, unless they head overseas (and lose the interest write off). Therefore this policy would be net positive return for the govt, and net negative return for the student (though giving increased flexibility and perceived independence, possible compensation) unless the student was going overseas. Simple solution, implement nationals 10% policy but put a bond on it requiring repayment of the bonus, and THEN reimburse the bonus if the student comes back to NZ within 10 years or something.

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  • limitedfaith

    “you are analysis is flawed”? Damn I hate doing that. I think I was going to write “you’re wrong”, but then moderated it. Changing your mind is for suckers.

    Also, there’s no reason borrowing would increase because of this policy, unless there are some people who are still too dumb to realise the opportunities that already exist.

  • student loans aren’t adjusted for inflation in new zealand, they have 0% nominal rate and thus a negative real rate so long as inflation is positive

    “there’s no reason borrowing would increase because of this policy, unless there are some people who are still too dumb to realise the opportunities that already exist.”

    I agree, I was saying that borrowing is only going to increse if people aren’t already borrowing as much they as they can, which I think they should be, I did.

    “the best outcome for the student is to never make a voluntary repayment…therefore this policy would be net positive return for the govt”

    The government has to get the money from somewhere, if they are lending it out at a negative real rate, how is it a positive return for the government?

    So you are suggesting that we effectively give them a 10% bonus in 10 years? that really doesn’t provide a big incentive to repay

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  • limitedfaith

    “student loans aren’t adjusted for inflation in new zealand, they have 0% nominal rate and thus a negative real rate so long as inflation is positive”

    If that is the case then you’d be even more misguided to ever make a voluntary repayment.

    “So you are suggesting that we effectively give them a 10% bonus in 10 years? that really doesn’t provide a big incentive to repay”

    No, not what I was suggesting, the below is incomplete.
    “Simple solution, implement nationals 10% policy but put a bond on it requiring repayment of the bonus, and THEN reimburse the bonus if the student comes back to NZ within 10 years or something.”
    I meant that allow someone to make a voluntary repayment and give them the 10%, but if they go overseas within x years then demand the 10% back. If they return within y years, give it to them again.

    Check out my comment on Kiwiblogblog, providing this scheme to people who were going to stay in NZ would save the govt money if the students went for it as, for the cost of a one-off 10% payment the govt would avoid the opportunity cost over the lifetime of a loan.

  • limitedfaith

    “The government has to get the money from somewhere, if they are lending it out at a negative real rate, how is it a positive return for the government?”

    It’s not, it’s a terrible return, hence it will be a positive return IF students went for the voluntary repayments. However, it’d be a negative return for the students, so I can’t imagine why they would.

  • “If that is the case then you’d be even more misguided to ever make a voluntary repayment”

    I completely agree and this is why economists think that interest free student loans are a bad idea. What many economists think would have been sensible is to index the loans for inflation so that they a constant real value over time and thus the same perverse incentives regarding repayment don’t exist.

    But now that the policy is in place it would be political suicide for either party to set the interest rate on loans equal to the inflation rate.

  • limitedfaith

    “What many economists think would have been sensible is to index the loans for inflation so that they a constant real value over time and thus the same perverse incentives regarding repayment don’t exist.”

    Even if the loans were indexed to inflation there’s a disincentive to repay, as indexing the loan to inflation merely increases the real interest rate to zero. Who’s going to voluntarily pay back a zero real interest loan?

    “I completely agree and this is why economists think that interest free student loans are a bad idea.”

    It’d be more accurate to say “that’s ONE OF THE REASONS why economists think they’re a bad idea”.

  • I guess regardless of what the interest rate is, or what bonus you get for paying it back, the fact that your loan is written off when you die and not passed on to your children is the single biggest disincentive to repay the loan.

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  • oliverquestforsecurity

    Frankly, I don’t think most students think like you do! (No offense intended in the comment!) Anyway, let’s not forget that your article to people unfamiliar with tertiary education reforms in the last two decades in New Zealand gives the impression students literally can borrow from the Government as one does from a bank.

    No matter how much economics you introduce into the debate, the vast bulk of students I’d say actually avoid getting excessive loans. I know of many people who in their first year of university study borrowed for living costs, then after seeing the huge amount of money they’d borrowed after the first year, started working part time and reduced their loan to just paying for fees.

    Personally, I have been soley borrowed for paying for my courses. The amount of hoops I’ve had to go through for that alone has been such a pain in the arse I’ve hardly even given any thought to borrowing for course costs. And the idea of borrowing for living costs is simply lazy in my mind (I have worked for a couple of days a week, sometimes as much as 30 hours a week, whilst studying), as well as grossly wasteful in terms of how much it adds to the student loan.

    What frustrates me is that is that there is no serious discussion around being more generous to students with fees and less generous with living costs – I for one can’t afford to pay for my own fees, which often go up by 5% each year in cost, yet I don’t borrow anywhere near the ‘maximum’ I can.

    Jim Anderton is probably the only Parliamentarian who understands the way we are grossly wasting human capital by driving Kiwis overseas with student loans – and why John Key, if he really is serious about bringing New Zealanders home, needs to start progressively softening the entire student loan scheme.

  • No offense taken! Through a combination of scholarships and working upto 30 hours a week I went through my first 3 years of University without a student loan. I didn’t start borrowing until the interest free policy was introduced. From my perspective it meant I no longer had to work as much and thus could concentrate more on my studies in the crunch years.

    Given that you don’t pay interest and your loan is written off when you die, the only reason I can see not to take out a student loan is if you think a future government will reverse the policy. I personally don’t think this will happen as there would be a huge backlash from students.

    Another problem related to the brain drain is that even though by leaving the country you are forced to pay interest, quite often the difference in wages more than compensates that.

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