2023 saw the end of student loan deferrals and the resumption of student loan repayments. In our 2024 Forward Looking + 2023 Year in Review post, we highlighted expected impacts of student loan repayments and identified the ending of student loan deferrals as one of the headwinds going into 2024.
This post will provide background and context for the millions of borrowers and the trillions in debt at stake. Let’s take a look at the fundamental structure and dynamics of student loans.
A student loan (SL) is a sum of money borrowed to cover the expenses of attending school. The most common SL use case involves borrowing money to pay undergraduate or graduate university tuition and is paid directly to the school. However, SLs can also be taken out to cover books, educational materials, and living costs. This includes various types of schooling, including trade, vocational, international, and K-12. Students need to take out a loan for each academic year they require assistance, though these can later be consolidated into one loan.
What are the different types of SLs?
SLs can come from either the federal government or private lenders. The federal government is typically able to offer lower interest rates and better terms than private lenders (which are predominantly banks and credit unions), but they set annual and aggregate borrowing limits that a student’s financial need may exceed.
Private Student Loans
Students will typically only use private lenders once they have taken the maximum amount available to them through federal loans. Some private lenders will finance and service their own loans while others will rely on partnerships with third-party investors or servicers.
Private student loans can have a wide range of terms, features, and intended customer bases given the many different institutions that can issue them. A central distinction among private SLs is the interest rate structure, which is either fixed or variable.
- A fixed interest rate is an interest rate that is decided at the time the loan is created and remains constant throughout repayment.
- A variable interest rate is an interest rate that will fluctuate throughout the life of the loan based on market conditions.
Some of the large private student lenders include Sallie Mae, Discover Bank*, Citizens Bank, and PNC. Sallie Mae owns a reported 55% of the student lending market, with other banks accounting for up to 10% of the market.
*Note: Discover Bank, as of Q4 2023, has decided to exit student lending
Federal Student Loans
Federal SLs make up around 93% of the approximately $1.7 trillion in SL debt in the United States and occupies about 30% of all non-mortgage consumer debt. These loans are financed by the government and serviced by various private companies hired by the U.S. Department of Education.
Federal student loans all have a fixed interest rate determined by Congress for any given year. The main types of federal SLs are categorized as subsidized, unsubsidized, and Parent Loan for Undergraduate Students (PLUS).
There are two main differences among these loans. Firstly, subsidized loans don’t require the student to pay any of the interest that accrues during the time they are in school, the six-month grace period after completing school, or during any deferment. However, students with unsubsidized and PLUS loans are responsible for all interest payments during these periods.
Secondly, these three loan types have different intended audiences. Subsidized loans are given out on a financial need basis to undergraduate students. Unsubsidized loans are available to graduate, professional, and undergraduate students, with no requirement to demonstrate financial need. PLUS loans are available to graduate and professional students, as well as the parents of all students.
While graduate and professional students can access either unsubsidized or PLUS loans, they would likely favor direct unsubsidized over PLUS loans for lower interest rates, assuming they have yet to reach their maximum available limit. The federal government determines each student’s borrowing limit and whether the loan will be subsidized using the information collected on the Free Application for Federal Student Aid (FAFSA) form. However, the loan amount offered will be decided by the school and the amount of financial aid the student is receiving.
How are SLs paid back?
SLs are unique in the amount of time that passes between underwriting and repayment. The terms of the loan are determined with money disbursed long before repayment begins. The funds disbursed each year continue to accrue interest throughout the time the student is in school and during the grace period. This causes the overall amount of interest paid to be higher than other types of loans because the unpaid interest capitalizes (i.e., the interest amount is added to the balance and begins to accrue interest on itself). Interest capitalization can be avoided if the borrower can afford to make interest-only payments while in school. However, not all students can afford to make payments while in school and may have to use the deferred payment method.
- Deferred payment allows the student to not make any payments while they are in school or during their six-month grace period. However, the amount of interest accrued during school and grace is added to the principal of the loan and accrues interest on itself.
- Interest-only payment requires the student to make payments during school, only on the interest due. This prevents the interest from capitalizing and keeps the total sum paid by the student lower than with deferred payment.
Non-subsidized federal loans default to deferred but borrowers can opt in to make payments on the interest during school so that the interest does not capitalize. Subsidized federal loans are the only SL type that do not require the borrower to pay the interest that accrues while the borrower is in school or during the grace period.
What assistance is available to students?
Both private and federal SLs offer a variety of programs and features to help customers that are struggling with their payments or would be likely to struggle in the future. The list below includes a non-exhaustive summary of some of the main offerings that are typical in the industry:
Delay payments on the loan:
- Forbearance (FORB): Temporary postponement of payments. Students are still responsible for the interest that accrues during this time. This time period can be up to 12 months for federal SLs and is typically much shorter for private SLs.
- Deferment: Temporary postponement of payments. Very similar to forbearance, but interest does not accrue for subsidized loans with deferment.
Change in the loan and/or loan terms:
- Loan Modifications: Alters the interest rate and/or loan term on a student’s loan for students experiencing long-term hardship. This differs from refinancing, as this doesn’t replace the current loan with a new one.
- Consolidation: Combining multiple loans to lower monthly payments or (in the case of federal) gain access to forgiveness programs. You do not need to demonstrate hardship or risk of default to qualify for federal consolidation.
- Refinancing: Alter the terms on one or combine multiple SLs to alter your interest rate and/or loan term. This does not have to be completed with the same institution that the loan was initially created with and is often done with whichever institution has the best rates at the time. You do not need to demonstrate hardship or risk of default to qualify.
- Income-Based Repayment: Alters your loan terms to make your monthly payment amount affordable based on your income and family size. Some borrowers may not qualify if their income is too high.
- Graduated Repayment: Lowers initial payments and gradually increases payment size over time. This is an ideal plan for those who are starting out with a low income but expect it to gradually increase over time (every two years).
Dealing with delinquency:
- Rehabilitation: Only available for federal loans. If the student completes nine consecutive payments, they will be removed from default and the default will be wiped from their credit history. (*Federal Only)
- Re-age: The student can be brought current if they make a predetermined number of payments (typically three payments). This will not remove the default from their credit history.
This is not a comprehensive list of all programs available through all federal and private loans. Options will vary widely for private student lenders.
What makes students unique borrowers?
SLs are distinct from other typical consumer loans in several ways, primarily due to the unique demographic and circumstances of the borrowers. The most notable demographic difference is the overall age of SL borrowers, as a significant portion belong to a younger age group. This age group typically has little to no credit history, generally causing them to fall into the low FICO population and making traditional credit decisioning challenging. Their age also indicates that they will likely have low financial literacy due to lack of experience. However, this lack of knowledge is often balanced out by the higher education levels attained as borrowers progress through school.
Another distinguishing feature of SLs is the option to heavily rely on a co-borrower for both decisioning and collecting missing payments. Relying on the co-signer is a strategy often only available for private SLs as most federal SLs do not require a co-signer or credit check. This co-borrower system not only provides a safety net for lenders, but also offers young borrowers an opportunity to secure loans they might not have qualified for on their own.
SL issuers and servicers accommodate their unique customer base by adapting the application process and product features. These enhancements include offering varied assistance programs (highlighted above), incorporating cosigner information into decisioning, and crafting modified collections strategies. The structures and terms of SLs are developed to fit the specific needs and conditions of the student population. Additionally, collections strategies incorporate the legal requirements of the co-signer and acknowledge the fact that a young, educated individual is likely to have higher than average income growth over time.
As with any lending product, it is incredibly important to keep the target consumers and distinctive product attributes in mind as you craft strategies across the lending lifecycle. This post aimed to simplify and consolidate the complex structure of student loans today. We have dissected the components and considerations of student loans and hopefully provided helpful context during a critical transition period.