Student Loans: The good the bad and the Ugly
Posted February 1, 2008on:
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