Why is the federal government involved in student loans?

Going to college iincreases earnings potential. So, it makes sense for students to borrow some of the money they need to pay tuition and living expenses and repay their loans out of the extra earnings they have because of their education. But the private loan market works well only for borrowers with collateral and/or strong credit histories. If you don’t make the required payments on your car loan, the lender will repossess the car. But the bank can’t take back your college education and many students have little history with credit markets.

The federal government can offer better terms to student borrowers, providing the liquidity they need to pay for college now, in anticipation of higher earnings in the future.

The core purpose of the federal student loan program is not to subsidize students. Other public funding—including state appropriations to public colleges and federal and state grant aid—are the main ways taxpayers help students pay for college.

The main purpose of federal student loans is to solve cash flow problems. Loans provide liquidity. The federal student loan programs now in effect allow all students to borrow—regardless of their financial circumstances. Since 2010, all these loans have been made directly by the federal government. And federal loans can be repaid through programs that limit monthly payments to affordable percentages of borrowers’ incomes.

Explore more in Student Debt: Rhetoric and Realities of Higher Education Financing

What is the relationship between tuition and financial aid?

The answer to this question depends on whether this issue is institutional grant aid or federal and state financial aid.

Institutional grant aid reduces the tuition prices facing students. It allows institutions to charge different prices to different students—frequently based on their financial circumstances but sometimes based on their high school grades, test scores, athletic ability.

When colleges raise their tuition, they frequently increase their aid budgets to help students pay the higher prices. But giving these discounts means the college gets less revenue relative to the published price. So, there is a close relationship between sticker prices and institutional grant aid.

Federal and state financial aid is different. Some people argue that the simple forces of supply and demand mean that when the government gives students more money, colleges will raise their prices. This idea is sometimes called the “Bennett Hypothesis” (after former U.S. Secretary of Education William Bennett, who popularized the idea in 1987).

The empirical evidence about this impact is weak—outside of the for-profit sector. But even if this aid does put upward pressure on sticker prices, it’s a small price to pay. The point of the federal student loan and grant programs is to increase demand for college. Without federal student aid, lots of low- and moderate- income students would not go to college—they simply would not be able to pay. So, if we can make higher education possible for more people, it’s a fair trade-off that there might be some upward pressure on sticker prices.

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Why would the same institution charge different students different prices?

Some students pay less because their finances make it difficult for them to pay. Others, who could pay full price, pay less because the institution wants to provide an incentive for them to enroll there instead of elsewhere.

This idea of “tuition discounting” is not a bad thing. Many highly selective institutions have long waiting lists of students willing and able to pay their sticker prices; however, these institutions want to enroll the best students they can and many of those students can’t afford to pay. Other institutions would have empty seats if they did not discount so generously; if they lowered the sticker price enough to fill the class, their total revenues would be too low to operate. By meeting as closely as possible each student’s willingness and ability to pay, institutions are able to attract a variety of students and stay operational.

Explore more in “Financial Aid and Enrollment: Questions for Boards to Consider”