Author(s)  
Lance Lochner, Alexander Monge-Naranjo

Rising costs of and returns to college have led to sizeable increases in the demand for student loans in many countries. In the U.S., student loan default rates have also risen for recent cohorts as labor market uncertainty and debt levels have increased. We discuss these trends as well as recent evidence on the extent to which students are able to obtain enough credit for college and the extent to which they are able to repay their student debts after. We then discuss optimal student credit arrangements that balance three important objectives: (i) providing credit for students to access college and finance consumption while in school, (ii) providing insurance against uncertain adverse schooling or post-school labor market outcomes in the form of income-contingent repayments, and (iii) providing incentives for student borrowers to honor their loan obligations (in expectation) when information and commitment frictions are present. Specifically, we develop a two-period educational investment model with uncertainty and show how student loan contracts can be designed to optimally address incentive problems related to moral hazard, costly income verification, and limited commitment by the borrower. We also survey other research related to the optimal design of student loan contracts in imperfect markets. Finally, we provide practical policy guidance for re-designing student loan programs to more efficiently provide insurance while addressing information and commitment frictions in the market.

JEL Codes  
D14: Personal Finance
D82: Asymmetric and Private Information; Mechanism Design
H21: Taxation and Subsidies: Efficiency; Optimal Taxation
H52: National Government Expenditures and Education
I22: Educational Finance
I24: Education and Inequality
J24: Human Capital; Skills; Occupational Choice; Labor Productivity
Keywords  
human capital
borrowing
student loans
default
repayment
income-contingent
credit constraints