Loans are risky.  When you take out a loan, a bank isn’t guaranteed any profits.

  • If you take out a loan for $100,000 on Tuesday at a rate of 7% over 30 years, and then you pay it back five minutes later, the bank has made absolutely $0.  I mean, there might be a service fee or something, but you get the point, right?  They got back the money they already had with no interest added. 
  • If you pay it slowly and exactly as you have to — without a penny more — the bank is doing great.  It has been fully repaid with the expected profits.
  • What if you pay your principal down early?  You will save money, but the bank will earn less profit from the transaction.
  • If you can’t pay the loan back at all and go into bankruptcy, then the bank doesn’t get any more money.
  • And if you miss a payment or two?  As long as you keep making some payments, the bank does even better: they get to charge you crazy high rates because you went into default and now they make even more money!  It’s better for the banks when you pay more.

So, when a bank (or mortgage company or financial institution or whatever you want to call it) makes plans for itself and its financial intake, it has to guess how much money it will receive off different loans (and investments, bonds, etc.).  The bank is basically placing a bet on how quickly, if ever, a loan will be repaid.  Too quickly means the bank gets the money faster but receives less money overall; too slowly means the bank waits longer for the money but gets more money in the long run.  A bank will want to diversify its portfolio so that it balances risky loans with solid loans.  That way, you will have some level of profits no matter what happens.

When the government evaluates the Direct Loan program’s portfolio, it needs to do something like this too.  To forecast how much money it is paying out in disbursements and measure that against how much money it is taking in from principal and/or interest payments, it has to do some risk-assessment and some math.**  But, as I’m sure you’ve gleaned from the last few years of subprime mortgage lending discussions and scandals and so on, honestly identifying risk and treating risk appropriately is pretty difficult.  It gets even more difficult when your applicants have little credit history (like college students!).  [Or maybe it’s really easy — but that is a huge issue and we’re moving on.]   This is a huge, complicated risk determination that really smart finance-people make, and there’s not a lot of recent literature about how the government does this.

A 2009 study by the National Association of Student Financial Aid Administrators called for more information about how and why students default on loan payments.  This study reviews the literature on student defaults (which it labels as outdated) and points to some factors that make students more likely to default on student loan repayment.  In its conclusory paragraphs, the study reminds its readers that if we were to stop providing loans to students who are at a greater risk of defaulting because they come from families with weak credit histories or who are at a greater risk of not graduating for any number of other reasons, then we will be undercutting the student loan program’s goal of making access to postsecondary education available to all students, regardless of income.

**I’m searching for summaries of the formulas that the government uses to forecast how much income it will have from student loan repayments given the clearly fluid repayment system we operate within.  If you have any resources or knowledge about that, please do send it over!  GAO, CBO, and Ed.’s websites have been unhelpful thus far. 

Student Loan Repayment, Part 2: what is the risk?
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