Explore How Student Loans May Become Bigger Credit Risks

The probability a borrower will default on student loans is increasing, according to a new study.

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Spikes in student loan default rates described in a new study could someday affect credit ratings.
Spikes in student loan default rates described in a new study could someday affect credit ratings.

Last month the Student Loan Ranger examined a post from the Fair Isaac and Company's (FICO) Banking Analytics Blog that concluded that large amounts of student debt alone are not enough to lower your credit score.

In fact, handled responsibly (meaning you pay back your loans on time and build up an excellent payment history), student loans can positively affect your score. But a new FICO report, "Is Growing Student Loan Debt Impacting Credit Risk?"—which describes the increased credit risk posed by student loans—leads the Student Loan Ranger to wonder how long this will be the case.

[Learn how some schools help students avoid student debt.]

Many of the report's findings will not be news to regular readers of this blog. The study describes how tuition increases have resulted in more borrowers with greater amounts of student debt (including a striking rise in six-figure loan debt) that is greatly outpacing other types of debt. This combined with a bad labor market has resulted in a severe spike in delinquencies and defaults.

To evaluate delinquencies, the FICO study evaluated both existing and new loans within two time periods, October 2005-2007 and October 2010-2012, and determined that "consumers opening student loans more recently are generally higher risk than those in older vintages."

But a closer look at the data from the two cohorts reveals that for new loans, the delinquency rate in 2005-2007 was 12.4 percent. It increased to 15.1 percent in 2010-2012, a 21.5 percent increase. For existing loans, the delinquency rate in 2005-2007 was 17 percent. It increased to 25.1 percent in 2010-2012, a 47 percent increase.

In other words, while the risk of delinquency for new student loans has remained relatively constant, there has been a significant increase in the risk of delinquency for existing loans.

That increased risk was also seen in the study's examination of the relationship between risk and FICO scores. (A credit score is a measure of the risk of lending that can be expressed as the probability a borrower will repay the loan.) A lender who wanted 10-to-1 odds of repayment of a student loan in 2005 could choose from borrowers with credit scores of 667 or greater.

In 2010, that same lender would have to limit the pool of borrowers to those with credit scores of 697 or greater to get the same 10-to-1 odds of repayment. Now, all borrowers, including those generally regarded as safer, have an increased risk of delinquency and are less likely to repay their student loans.

[Find out how public service can pay off with scholarships.]

Other data points from the study indicate the increased riskiness of student loans. First, the median FICO score for borrowers taking out new student loans has declined from 659 to 641, indicating that lenders have been making loans available to consumers with worse credit scores. Second, borrowers in 2010-2012 with $40,000 or more in student debt are far greater credit risks compared with the total population than they were in 2005-2007.

Ultimately, the study concludes that FICO scores are still a good measure of overall risk, indicating that the current risk of student loans is adequately reflected as a part of the overall risk measured by Fair Isaac and Company's algorithm. But if student debt and default rates continue to increase and the economy does not improve, the Student Loan Ranger wonders if the company will be forced to change its algorithm to reflect that increased risk, especially for those with high levels of student debt. If it does, we may see high levels of student debt negatively affecting credit scores.

Another concern addressed by the study is if the trillion-dollar student loan market, with—according to the Federal Reserve Bank of New York—an effective default rate of 22 percent, is a bubble about to burst.

[Explore how to start paying off student loans.]

The study notes that "The student loan situation parallels the early mortgage crisis in some ways," but cites as a key difference that defaulting student loans are a smaller part of the economy and are therefore unlikely to cause the same widespread economic damage as the foreclosure crisis.

Nonetheless, the Student Loan Ranger believes both the current default rate and the likelihood of a continued rise in defaults should be a major concern for policymakers and individual borrowers—whether or not there is a bubble. For better or worse, student loans are a key component of access to higher education. And higher education still provides significant value in the form of improved job prospects and increased earnings.

The Student Loan Ranger suggests policymakers increase funding for existing programs like Pell Grants and remove the limits on federal loans for undergraduates to ensure they can fully fund their education using federal loans with their important borrower protections. There are also innovative new initiatives being proposed, including allowing borrowers to refinance loans and the Student Loan Forgiveness Act.

[Check out these two new ways to repay student loans.]

For borrowers, it is important to take steps at every stage of their educational career to ensure they can manage their student loans and avoid the penalties for default that can include seizing tax refunds and garnishing wages. A great resource is our new E-book, Take Control of Your Future.

Isaac Bowers is a senior program manager in the Communications and Outreach unit, responsible for Equal Justice Works's educational debt relief initiatives. An expert on educational debt relief, Bowers conducts monthly webinars for a wide range of audiences; advises employers, law schools, and professional organizations; and works with Congress and the Department of Education on federal legislation and regulations. Prior to joining Equal Justice Works, he was a fellow at Shute, Mihaly & Weinberger LLP in San Francisco. He received his J.D. from New York University School of Law.