Interest-free student loans

Dr Eric Crampton
Khyaati Acharya
26 August, 2016

2016 is closer to 1240 than you might think. In 1240, Robert Grosseteste, Bishop of Lincoln, established the first ever documented student loan system. Scholars would take an oath to prove they were of modest means, and deposit some valuable object into an embellished chest - formally called St Fideswide’s Chest - held on the Oxford university campus. Scholars held the chest as collateral for the loan.

On some fronts, we have progressed considerably since the rudimentary student loans of 800 years ago. But in other ways, not so much. Loans back then would not typically carry interest, as the Church at the time thought interest was sinful. Politics today around student loans have a similar tinge of the dark ages.

New Zealand’s modern student loan system was established in 1992, tasked with providing bulk payments to students for tertiary tuition, course-related costs and living costs, disbursed at slightly below-market interest rates. No collateral was required and students could defer repayment of the loan until the benefits of tertiary education were realised in future income. The scheme remained largely unchanged for almost a decade. Tertiary participation rates soared. There were around 140,000 full-time students in 1994. By 2004, EFTS numbers had increased by more than 100,000.

Upon winning the 2005 general election, the NZ Labour Party eliminated interest charges on student loans for all New Zealand-based borrowers.

It was a controversial move, criticised by the Opposition for being little more than an election bribe - but ultimately supported by National when they came to power in 2008. A decade on from the zero-percent loans policy is a good time for a look back at how things have panned out. This week, The New Zealand Initiative released its report, Decade of Debt. The zero-percent loans scheme was sold as a way of improving access to tertiary study and reducing students’ debt burden.

It has not done well on either measure.

Tertiary participation rates peaked at 14% in 2005, just prior to the zero-percent loans policy. Since then, participation rates have dropped to just over 10%. The number of full-time student equivalents plateaued in 2005 and have fluctuated around 230,000-255,000 over the past decade. Work by Nigel Healey and Philip Gunby at Canterbury University found no improvement in Maori or Pasifika enrolment rates with the policy change.

And, despite the interest-free loan policy, more than twice as many students from decile 9 and 10 schools progress to tertiary study than do students from decile 1 and 2 schools. Where zero percent loans were supposed to improve tertiary accessibility, instead we find constraints in the system that work substantially against lower income students.

To put it simply, the government cannot, at zero percent, lend out enough money to meet the needs of the most financially stretched student without simultaneously encouraging everyone else to borrow far too much. And so it must cap how much students can borrow. Consequently, as the Child Poverty Action Group reported earlier this month, some students have had to turn to credit card debt, or to part-time work that hinders their study, to fill the gap. Neither of these improves tertiary accessibility.

Neither has there been any improvement in the student debt burden. Instead, the median student loan now takes a few months longer to pay off than it did prior to the zero percent loan policy. It might seem a paradox, as borrowing at zero percent should reduce the amount of time it would take to pay off any given loan. But remember that people will borrow more when interest does not apply, and will not be in a hurry to pay it off when they’re also saving for a house deposit.

And overseas-based borrowers remain a substantial problem. In 2009, those overseas borrowers owed $1.9 billion, and today they owe $3.4 billion. Their overdue debt has snowballed from $110 million in 2005 to more than $800 million in 2015.

The expressed intentions of the policy, assuming it was not, as National then deemed it, simply a cynical election bribe, could have been admirable. Improving access to tertiary study is a good thing to do. But the $600 million in subsidies provided this past year alone - and forecast to rise well into the $700 million range soon - simply has not done that job. And it is simple to see why it couldn’t do that job.

New Zealand has an excellent income-based student loan repayment system. Everyone with student loan debt pays a 12% tax on every dollar earned over $19,084 until the debt is paid off. Whether the interest rate is 0%, 2%, inflation plus 3%, or any other percent, the minimum fortnightly payments would not change. What changes instead is the duration of payments. If the interest rate is higher, every dollar borrowed takes a little while longer to pay off. But the fortnightly repayment burden is no different.

How much longer would repayment take? Suppose you left tertiary study with the median student loan balance, inflation adjusted upwards from the most recent stats available: $16,700. And suppose that you followed the typical earnings path for someone with a Bachelors degree, as published in the most recent StudyLink data. Finally, suppose that you paid only the minimum 12% on every dollar earned above the threshold. If the interest rate were 2%, it would take an extra three months to pay off your loan. If the interest rate were 4%, it would take an extra 6 months. At 6%, it would take an extra 10 months. At 8%, 14 extra months. None of these are especially terrifying figures.

Of course, not all investments pay off. The dairy farmer who borrowed at 8% to buy paddocks just before the crash in milk prices might have debt that outstrips the farm’s assets and wind up going bankrupt. And someone taking on tens of thousands of dollars in student debt in pursuit of degrees with little to no chance of employment will take a very long time to pay off their debt, regardless of the interest rate.

Let’s consider a plausible bad case. Suppose you took out $60,000 in student loans for a degree that had no real payoff. Your starting salary winds up being $20,000, then you follow the normal path of annual salary increases after that. Even under zero percent, it would take over 23 years to pay off that debt. Even a 2% interest rate would add four years of repayment. But the problem really isn’t interest, is it? The problem is taking out tens of thousands of dollars of debt for a degree that doesn’t lead anywhere.

And that’s why we recommend a strong refocusing of how government spends its money. If the point of the zero percent policy was to improve tertiary accessibility, and to reduce the student debt burden, the zero percent policy has failed. We suggest better uses for the money currently going toward interest rate subsidies.

First, and most importantly, put the money into better tertiary preparation at secondary school. Labour was dead right two weeks ago when it said that too many students get very poor career guidance. Kids stuck in schools with little tradition of sending graduates on to tertiary education will not know which NCEA courses they need to take to have a shot at success after school. They need guidance in making those choices. They also need better guidance and help in choosing degree pathways that lead to jobs and success rather than to decades of misery.

Second, some of the savings from reinstating interest on new student loans could be put towards means-tested assistance for students.

The shift would be strongly progressive in effect. Instead of giving substantial interest rate subsidies to the kids who currently wind up going to tertiary study, who are typically from richer backgrounds and who are typically more likely to wind up on higher earnings, we would be investing in secondary schools so that kids from less privileged backgrounds would have a better shot at tertiary success.

Labour’s Chris Hipkins dismissed this progressive shift as right-wing claptrap. It is time that Labour, and National, stopped throwing good money after bad, ceased their partisan claptrap defence of their joint failure, and gave their collective heads a shake. We could be doing so much more good with the hundreds of millions of dollars a year we’re funnelling into interest rate subsidies.

If only we could move our thinking out of the dark ages.

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