Despite today’s low borrowing costs, many gainfully employed college graduates are finding that they cannot refinance student loans taken out under higher interest rates than they’d be eligible for today.

The growth in the cost of a college education has outstripped inflation for decades and there’s no end in sight. Student loans are an investment in human capital. You can’t repossess an education. And with interest rates expected to rise, there’s little incentive to lower interest rates incurred when today’s graduates were college freshmen.

The Department of Education hasn’t made it easier. Its disclosures on the performance of student loan servicing companies has been inconsistent, making it difficult for the public to evaluate their quality. And practices banned in other consumer-debt fields are still used by student-loan servicers.

“My understanding is that there is nothing in the federal consumer financial laws which prevents principal reduction or other loan modifications,” said Rohit Chopra, student loan ombudsman for the Consumer Financial Protection Bureau (CFPB). “Banks may need to comply with accounting guidance prescribed by state and federal prudential regulators.”

He said public comment suggests that refinance options on private student loans could offer relief for responsible borrowers – those with high-rate private student loans who have made their payments on time, with consequent improvement in their credit scores since their first borrowing. But borrowers who have graduated and joined the workforce may be unable to refinance at a lower rate that reflects their demonstrated ability to repay. He said comments suggest that policymakers can play a role to jumpstart a refinance market, allowing eligible borrowers to refinance their debt at lower interest rates, potentially saving thousands of dollars.

A Lack Of Competition

Mark Kantrowitz, senior vice president and publisher at Las Vegas-based Edvisors.com, part of Edvisors Network Inc., noted that student borrowers’ credit score while they are still in school declines as they near graduation, so their interest rate gets higher. If students repay responsibly for two years they become a proven asset, with a better credit score than when they came in as freshmen. There should be a good market for them in income-based repayment, but that hasn’t occurred on a widespread basis, though there has recently been talk at the federal level about doing so. Meanwhile, without market competition, there’s little incentive, in a low interest rate market, to lower a borrower’s interest rate from pre-graduation highs.

“Unlike other asset classes, there are very few servicers in the student loan business,” said Perry O’Grady, principal of Silver Sword Capital Partners, a Boston-based business-to-business financial products marketing firm. Silver Sword partners with various firms in the private-loan arena, and represents Sallie Mae to financial institutions seeking to add a student loan product to offer their existing customers. Sallie Mae originates and services the loans in the partner institution’s name and the partner institution earns a fee at origination, providing a risk-free option to the bank or credit union that delivers incremental fee income. But the financial institution has no discretion in refinancing the loan, which is owned by Sallie Mae and is carried on Sallie’s balance sheet.

The loan servicing environment is dominated mostly by big players, because without scale, loan servicing is a thin-margin business, O’Grady said.

Salem Five Bank offers products through partnering with Sallie Mae. Its website offers both variable interest rates and fixed interest rates, rewards for paying on time, and a 0.25 percent interest rate reduction while in school for making scheduled payments by automatic debits. Students can borrow up to 100 percent of their school-certified costs, and can choose from deferred repayment, fixed repayment or interest repayment.

Wells Fargo, one of the largest bank institutions in the student-loan business, offers a private product for parents of undergraduate students. Regions Bank, Commerce Bank and Fifth Third are also super-regionals in the student loan arena.

Few lenders do refinancing of private loans, and if they do, it’s often only with their own loans. “There are some refinancing options available, but it is a tremendously underserved market,” O’Grady said.

The Next Bubble?

Loan securitization has historically been an efficient way to put risky financial obligations into a more liquid market, at a reduction of risk, but as was learned from the mortgage debacle, it’s easier to place a loan into securitization than to rework it when things go wrong. “Once a loan is securitized, the ability to refinance is limited,” said Kantrowitz. Investors don’t want to lose their expected profit through refinance; there’s more incentive to change the repayment terms of what’s already on the balance sheet, by extending the repayment period, for example.

Modification of the principle balance on federal loans is not a possibility unless the borrower has been in default, which echoes the same moral hazard as did the recent problems in the mortgage industry.

Many consumer finance options are available through specialty lenders, e.g. non-banks such as San Francisco-based Social Finance Inc. (SoFi). That peer-to-peer lender targets professionals with high education costs but also high earnings potential, and at yearend 2013 had funded $275 million in loans to students and graduates from more than 100 select universities.

In December, SoFi announced the closing of its inaugural securitization of post-graduate student loans, the first such instrument from a peer-to-peer lender. Approximately $152 million in senior notes were sold to institutional investors. With interest rates set to rise, access to capital markets marks a watershed in the matter of such instruments. 

Email: coneill@thewarrengroup.com