Private Student Loans: The Subprime Mortgages of the College World

Student loans and student debt
Student loans and student debt

With more than $1 trillion in student loans outstanding, many students and graduates are struggling under the weight of huge amounts of debt. But as a report from the Consumer Financial Protection Bureau reveals, one fairly small part of the student loan market appears to be most responsible for many of the problems borrowers face: private student loans.

According to the CFPB report, borrowers have more than $150 billion in private student loan debt. Yet the market for private student loans is still a pretty small niche, making up just 7% of total student loans originated in 2010-2011.

But go back a few years, and you would have seen a much different story. During the mid-2000s, investor demand for securities backed by private student loans led to a big growth surge in lending activity. Just as subprime mortgages opened up the housing market to less creditworthy borrowers, so too did lax lending standards for many private loans sow the seeds for trouble later on, with students taking out loans they didn't need and borrowing more than they could afford.

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The CFPB report points out some of the consequences. More than 850,000 loans have defaulted since 1999, involving more than $8 billion in debt. Because private student loans don't come with the same deferment, forbearance, and debt forgiveness options that many government loans have, borrowers have a lot less flexibility in handling problems once they arise. Moreover, even bankruptcy isn't a good option for troublesome private student loans because of tighter bankruptcy laws governing courts and their ability to discharge student loan debt.

For-Profit Problems

The report notes the big role that for-profit colleges have played in boosting private student loans. Citing 2008 statistics, 42% of undergraduates at for-profit colleges used a private student loan, compared to just 14% of undergraduates overall.

%Gallery-157530%But the report doesn't call out all private student loans. As the Education Finance Council noted in its response to the study, the CFPB found that default rates on nonprofit, state-affiliated lenders are about half those of for-profit lenders.

Despite recommendations from the CFPB to make the private loan process more transparent and easy to understand for prospective borrowers, the real challenge comes from rising college costs. As long as young people need a college education in order to succeed, demand will keep prices high and drive many students into credit problems that will take them years to overcome.

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Motley Fool contributor Dan Caplinger only spent a modest amount of his loan money on pizza. You can follow him on Twitter here.