How we finance college impacts the real cost of higher education – A look at the American vs. Australian student loan system

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“What can you to say to reassure me…that I will be able to sufficiently support myself after I graduate?”

–Jeremy Epstein, 20-year-old exercise science major at Adelphi University asking the first question at the second presidential debate of 2012.

 

In his response to Jeremy, Governor Romney rightly pointed out that there are two ways to tackle this problem.  One is through job creation.  The other is through the cost of higher education.  Unfortunately, Romney then referenced a Massachusetts program that gives scholarships to students receiving marks in the top 25% on the state’s high school exit exam. While that might relieve some financial burden for top high school students, it is by no means a systemic solution since it offers nothing for the other 75% of students.

Human capital investments are particularly challenging.  For the borrower, it is uncertain whether he’ll be good at the skill he is seeking to acquire and uncertain what skills will be valued in the future.  Unlike in the capital market where an individual can diversify his holdings to mitigate risk, in the labor market an individual has to make employment decisions with long-lasting consequences and limited ability to diversify.  For the lender, it is also uncertain whether the borrower will earn sufficient income to pay back his loan.  But there is the added worry that if he doesn’t, there is no collateral he can seize.  Doing so would at best be indentured servitude; at worst, slavery.

In response to these challenges, the U.S. and Australia have taken different approaches to higher education finance.  In the U.S., colleges and universities set tuition with little price differentiation based on the value of the degree one is seeking.  Jeremy’s exercise science degree would have cost him the same as an economics one, despite the varying value of the degrees.

To assist students in financing their education, the U.S. government offers grants and loans based on financial need.  The loans are mostly non-dischargeable, meaning that they cannot be reduced or eliminated in bankruptcy.  Students can apply for deferrals or grace periods but interest and fees continue to accumulate during this time.

Under the American system, the longer it takes you to pay off the degree, the more the degree costs.  For students from poor families or for those with lower-paying careers this blunts the return they would otherwise get on their degree.  This creates drag on social mobility.

The Australian system looks quite different.  Degrees are priced on a combination of their market value and national priorities.  For example, high-returning medical, law, and economics degrees cost ~1.7x more per term than lower-returning education and nursing degrees.  Australia further sets national priorities—in mathematics, statistics, and science—and prices these national priority degrees even lower than the nursing and education degrees.

Australian students have three options to pay for their degrees:

  • They can pay upfront tuition at a 10% discount;
  • Pay a portion upfront at a 10% discount and the rest in income-contingent loans; or
  • Pay the entirety in income-contingent loans.

An income-contingent loan is what it sounds like—a loan whose repayment terms vary with a borrower’s income.

Australian students don’t begin to repay their loans until their income exceeds US$51,135.  If their income dips because they go back to graduate school or can’t find a job or any other reason, they don’t pay anything until their income is back above this threshold.  No fees or interest accumulate during this time.  When income is above the required threshold, repayment ranges from 4% to 8% of income, increasing as income increases.  Because of this, the more money a borrower earns, the faster he pays off his loan.

Australian student loans are indexed to their consumer price index and therefore have a 0% real interest rate.  Yet because of the time value of money, a dollar today is worth more than a dollar tomorrow.  The time value of money means that the longer it takes a borrower to pay off his degree (on a zero real interest loan), the less the degree costs.  Under the Australian system, those taking longer to repay and therefore paying less are those who earn the least.

Exhibit A: Real cost of a $25,000 college loan under US and Australian systems

 A hypothetical U.S. student with US$25,000 debt at graduation who doesn’t make any payments for ten years has a higher loan burden at the end of this period than an Australian student with the same amount of debt.  Nominal interest rates above inflation increase the cost of U.S. degrees over payback length, while the time value of money decreases the cost of Australia’s zero-real interest degrees.
 

We are all born with an endowment of human capital that was not of our own making.  We can improve upon it.  But we have to invest to do so, often without knowledge of what the future will look like or of whether we’ll be good at the skill in which we’re investing. A higher education finance system can be agnostic as to career decisions or give clear signals as to the market viability of a degree.  A higher education finance system can make things easier when times are hard or can make things harder when times are hard. Australia’s experience shows that there is more the American higher education finance system can do to answer Jeremy’s question.

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Sarah Dillard is a human capital expert based in Washington, DC. Her writings can be found at A Human Capitalist . She is currently working for a venture capital client, advising them on their education investments. She previously co-founded the National Math and Science Initiative and served as Special Advisor to the U.S. Assistant Secretary for Planning, Evaluation, and Policy Development. She is a graduate of Duke University, the Harvard Kennedy School, and the Harvard Business School.  She started her career at Bain & Company.