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In a proposed budget plan, interest rates for federal student loans will be linked to the government’s cost of borrowing.
In President Obama’s new budget request, which spans a lengthy 244 pages, several large changes to the federal student loan program were announced.
Other plans for the year’s budget include additional funding for community colleges, more federal work-study programs and increasing the maximum amount that Pell Grants deliver.
But one of the most discussed items dealing with higher education is the change to the student loan interest rate. Instead of the current system, where student loan interest rates are fixed by law and subject to congressional changes, the President’s new budget proposes changing the interest rates to market-based fluctuations.
The plan is a way to reduce the growing student loan debt problem in the country, and to reduce the overall cost of higher education. Student loan debt passed the $1 trillion in late 2011 or early 2012, and the number is not set to decrease unless large scale plans are enacted.
If the interest rate change became law, it would reduce the current cost of students’ payments. But interest rates change constantly. Since the market is on an upswing, the rates will likely rise past the current fixed rate. Unless a cap is set, student borrowers could wind up owing even more than they do now in future years.
But Obama’s plan is just that — a plan. It is not a law yet.
And critics dispute whether or not the plan has any chance of passing. Some experts believe the plan stands little chance of becoming a law, whereas others believe it will pass in the next few months.
Interest rates on unsubsidized Stafford loans are set to double to 6.8 percent on July 1, 2013 unless Congress enacts another freeze on the rates. If Congress does not pass another freeze, borrowers are predicted to owe a significant amount more.
According to a U.S. Public Interest Research Group report released Tuesday, the millions of students who owe debts on these loans will be forced to pay $1,000 or more per year.
At the very least, even if the interest rate aspect does not pass, it could still open up dialogue about the student loan debt issue. It could begin congressional debates about unique ways to reform the student loan program and how to reduce the national student debt figure.
JPMorgan Chase and Co., the largest bank in the United States, is exiting the private student loan industry.
It has scheduled to cease accepting applications on Oct. 12, 2013 and will make its final private student loan disbursements before March 15, 2014.
Experts were divided on what this news means to current and future private student loan borrowers as well as the private college lending industry as a whole.
A Warning Sign and an Exit Sign
Oliver McGee, the former United States Deputy Assistant Secretary of Transportation and Vice President for Research and Compliance at Howard University, said that JPMorgan is just making a wise business decision.
He said that the bank can’t afford another probable domestic-based student loan bubble bursting after the devastating impact the subprime mortgage crisis had on JPMorgan’s balance sheet.
McGee suspects that the student loan bubble is beginning to burst right now and that JPMorgan’s exit is suggesting that the market for private student loans will contract as the bank effectively closes a section of its cash flow.
“Sounds a lot like the subprime loan department shutdowns in the large banking sector that sent similar shock waves onto Main Street back in 2007,” said McGee. “Similar spin machines of sudden subprime loan unit shutdowns occurred much the same way.”
Ever meticulous, McGee recounted that JPMorgan is actually the second major private student loan lender to leave the industry since in 2012 US Bancorp did the same. That leaves only a handful of other household names as the remaining private college loan lenders, namely Wells Fargo, Discover Financial Services, PNC Financial Services Group and Sun Trust Banks.
“Watch for some of these large private banking institutions, now facing growing risks and exposures to student loan defaults, to begin to signal they’re heading for the exit doors of the student loan gaming racket,” said McGee. “This will leave the largest player holding the student loan bubble, the federal government’s Sallie Mae, now privatized since 2004.”
Far from accepting the belief that the recession is over, McGee points to rising costs across housing, food, durable goods and services and other sectors of the economy that show the nation is still in a vice-grip of troubling economic times. Another financial bubble bursting will be far from a positive sign that the nation is “recovering.”
Bank Saves Money, Private Borrowers Lose Money
Jason Lum, a College Consultant with ScholarEdge, believes that JPMorgan’s departure from the private student loan market is going to be nothing but trouble for borrowers. He outlines what is to come on account of such a large financial titan leaving an already small market.
“A basic rule of economics kicks in: rates should go higher and lending terms should be more restrictive for borrowers with fewer players,” he said. “This applies to everything from the airlines, to software developers, and in fact to virtually any product that enters the private market. On the other hand, because federal student loans are so heavily relied upon, I think that JP Morgan’s exiting from the private student loan market will have a fairly negligible effect on the average student loan borrower.”
If Lum is right, then Congress can still influence the situation by making federal student loans more restrictive. Should it do so, he predicts that private lenders will increase their fees and grab more market share.
As bad as private student loans can be for some borrowers, Lum has a strong belief in variety and a market with multiple choices for consumers and thus thinks that JPMorgan’s exit is not something to be welcomed.
“I think what JPMorgan is realizing, as is Congress, is that there is a student loan bubble out there that is poised to explode at any moment,” he said. “Despite laws that make it virtually impossible for borrowers to dispose of student loans in bankruptcy, JPMorgan probably saw the risk involved of this bubble exploding, and concluded that it simply negates all the profitability out of this loan product.”
The Federal Government and Private Lending
Carolyn R. Tatkin, a Partner at the Frutkin Law Firm, said that private student loan lending is actually a small part of JPMorgan’s portfolio and that other lenders will be quick to fill the vacuum left by the large bank.
Their increased market share and any profits that come with it may be short-lived though since Tatkin believes that more and more borrowers will prefer the federal government’s direct lending program.
“While there is always worry when the government takes control of a market, the lower rates and flexible repayment plans have made things slightly easier on student borrowers, in spite of the continuing high cost of education,” she said. “I do not believe student loan borrowers will be impacted significantly by JPMorgan’s exit.”
Even though JPMorgan’s exit has a debatable level of impact on existing and future borrowers, one expert feels that this event was a long-time coming.
Mark Kantrowitz, Senior Vice President and Publisher at Edvisors, believes that JPMorgan’s exit from the private student loan industry was inevitable due to the ending of the Federal Family Education Loan program (FFEL).
He argues that JPMorgan lent both federal and private college loans through the FFEL, but once it ended in July 2010, they were reduced to a narrowed income stream that only came from private lending.
However, students should welcome the bank’s departure since federal student loans have more flexible repayment plans.
“They are also more available and less expensive,” he said. “So borrowers should fare better under federal loans and should always borrow federal first. I doubt there will be any change from the remaining lenders, since the change does not affect demand for private student loans by much.”
Private Lenders Still See Opportunity
Mike Cagney, CEO of SoFi, said that JPMorgan’s departure shouldn’t have much of an impact on private student loan borrowers and that federal student loans are better for undergraduates anyways. He did note that private student loans held an importance in college financing though.
“Private lenders can still add value [by] refinancing graduates, and lending to grad students in school,” he said.
Cagney sees one problem going unaddressed that could be more important that selecting either private or federal college loans: financial education.
“The problem with student loans is that there is no financial literacy to explain to borrowers how much they can borrow and expect to pay back given their career options with their school and degree choice,” he said. “ Schools have no accountability to ensure what they charge for tuition commensurates with the value of that education. Until these two issues are addressed, we can expect tuition to continue to rise well ahead of inflation and debt burdens to grow.”
In contrast to many beliefs, Cagney thinks that private student loan borrowers pay back their debt more than federal student loan borrowers. This is because private lenders conduct thorough underwriting which translates into lower interest rates for certain types of borrowers, such as graduates.
One borrower at SoFi said that private student loans even offer a better deal than federal ones.
“Initially, the federal government was my lender but I was able to get a better rate with a private student loan lender and really liked the community aspect of SoFi,” said Jose Guzman, a SoFi borrower.
Guzman doesn’t think that JPMorgan’s exit from private college loan lending will have much of an impact since the market will only get bigger as higher education becomes more and more of a necessity to survive in society, let alone get ahead.
He predicts more lenders will begin appearing on the scene in order to both offer a desired product and turn a profit from innovation, a key hallmark of SoFi that attracted Guzman in the first place.
“I chose SoFi because they are funded by investors that have a genuine interest in the success of the borrowers,” he said. “It helps that the investors are alumni from the schools as well.”
The Securities and Exchange Commission (SEC) has proposed regulation that would allow for investors to buy stock in companies over the internet using crowdfunding exchanges.
If the SEC’s rules are implemented, this would allow for investors to buy stock in firms that are not large enough for initial public offerings, thus allowing people to get in on “the ground floor” of a budding startup.
This proposal from the SEC comes in the wake of the JOBS Act, which was passed last year.
“The JOBS Act opened up the opportunity to raise capital from purely the dominion of the large company into a chance for any company to raise money from the general public,” said Jonathan Frutkin, Principal of the Frutkin Law Firm.
“The SEC was tasked to come up with common sense regulations that facilitated investment into more than just large stock-exchange companies. Once regulations are finalized, you will see small businesses, that employ most Americans, with a new option to raise capital for expansion.”
By allowing average Americans the opportunity to invest in equity crowdfunding, they can participate in local companies and stimulate local businesses. Since the amount each individual can invest each year is capped, there is little opportunity of anyone being wiped out on a poor investment.
Impact on the Lending Scene
While the SEC’s proposal is great news for budding investors, it may not be good news for business loan lenders. After all, when businesses are able to crowdsource funds in exchange for equity, they may have little need to get into debt borrowing business loans that will cost interest payments over years or decades.
But not all experts are so pessimistic.
Paul Singh, the CEO of dashboard.io, said that the SEC’s decision won’t impact any businesses that are seeking business loans. This is because equity-based financing is very different than debt-based financing.
When investors buy equity in the form of stock, they do not receive interest payments from the corporation they are invested into. Instead, they own part of the company and may profit or lose their investment based upon a change in stock price. Business loan lenders on the other hand, only profit off of interest they earn on money that is lent out.
“In my opinion, most of this new capital will be directed towards the companies that have already raised money from ‘traditional’ VCs,” said Singh. “We won’t see new money going to new ventures until there’s a better understanding of the risk factors involved for everyone.”
Dr. Walter Schubert, Professor of Finance at La Salle University, said that the SEC’s proposed rules would allow startups to gain funds that they never would get from banks, such as business loans, or traditional venture capitalists. However, problems remain ahead.
“First, a lot of people will throw in savings that they probably should not invest,” he said. “Picking winners is not easy even for professionals, for less knowledgeable people it will likely be worse.”
He also explained that while some ventures will be funded by a new wave of investors and experience massive success, on average most people will lose money, prompting additional government involvement.
Past and Future
Bill Clark, President of MicroVentures, said that originally, the crowdfunding limit that companies could raise was capped at $5 million before it was determined that $1 million would limit the amount of risk exposed to investors.
“Personally, I think that $1 million is enough capital for a startup that is utilizing crowdfunding,” said Clark. “This should give them enough capital to prove their concept, get customers and go for a larger round with angel investors.”
Clark predicts that established businesses will end up using their sizable customer followings to good effect by expanding through crowdfunding. A second wave of companies will be young startups seeking capital.
Even though some of these young startups won’t pay off for investors, novice investors may still end up profiting, even from poor decisions.
“We will see a lot of people investing in startups for the first time and make mistakes based on hype and not investing for fundamentals,” he said. “As they start to learn from their mistakes they will grow as investors and make better choices which means they will be more selective.”