As President Obama implicitly acknowledged in his recent plan to make attending Community College free for two years, education in America is at a crisis point. Geographies of class and color segregation are cementing inequalities in schools. Overworked and faced with crippling debt, many low-income students and students of color drop out of university or opt out entirely.
The student debt burden also divides starkly along racial lines. African Americans and Hispanics are about twice as likely to have student loan debt as whites. Among people with at least some college, 22 percent of white students have student loan debt, compared with 43 percent of African Americans and 36 percent of Hispanics. Minority students are also significantly more likely to take out a riskier combination of federal and private loans at a higher interest rate.
Private student lenders have recently come under fire for abusing lending practices from financial regulators. What is less understood is the ways in which private lenders may be violating fair lending laws by singling out minority and low-income students for excessively high interest rates.
Private student lending has a chimera-like presence in the loan market. Students are not typically earning an income and are often first-time borrowers. Lenders have to find some way to separate the students more likely to default from those less likely to default in a pool of loan applicants who have little to no credit history. The students' future earnings are inherently uncertain. The formula that private lenders use to do this analysis is often hidden or remarkably opaque.
We do know that private lenders use some suspect factors to establish loan terms and conditions, including interest rates. According to advice provided by lenders and industry experts to the U.S. Government Accountability Office, some of the key factors that lenders use to underwrite and price their loans include program length (for example, two-year versus four-year program), type of school, school graduation rates and schools' cohort default rates. Some loan programs also use academic criteria, such as a student's GPA.
The use of a "cohort default rate" as a pricing tool may provide an essential key to unlocking the puzzle of high minority interest rates. According to the Consumer Financial Protection Bureau, the cohort default rate is a measure of the federal student loan repayment history of a particular group or "cohort" of borrowers. The Department of Education publishes the cohort default rate to penalize poorly performing schools by restricting access to federal loan programs, not to lend a helping hand to private student lenders in their underwriting and pricing decisions. However, this index is being used by a number of private student lenders who want an easy proxy for a student's likelihood of repaying.
The use of this index is concerning because racial and ethnic minority students are disproportionately concentrated in schools with higher default rates. For instance, the Consumer Financial Protection Bureau found that African American students attending public four-year institutions were almost four times more likely to attend schools with a cohort default rate above 8 percent. Hispanic students attending private four-year institutions were over seven times more likely to attend schools with a cohort default rate above 8 percent.
However research points strongly to the unfairness of punishing minority students with high interest rates simply because of the high-observed default rates at the schools they attend. Empirical evidence shows that default rates are poor vehicles for assessing the quality of schools or of various types of loans. Once borrowing behaviors and student background characteristics are considered, differences in default rates largely disappear.
What this means is that minority students are being offered higher interest rates than their peers with no real justification. The crushing burden on student loans already falls heaviest on low-income students and students of color, and private lending practices are adding to this load.
Under the Equal Credit and Opportunity Act, it is unlawful for a creditor to discriminate in any credit transaction. One form of discrimination recognized under the Act is a "disparate impact," which forbids practices that have a disproportionately negative affect on racial minorities, where those practices don't meet a legitimate business need. A 2007 lawsuit against Sally Mae cited the use of factors such as cohort default rates as the basis for a race discrimination claim under the Equal Credit and Opportunity Act. The case was eventually settled out of court.
One of the barriers to successfully litigating around this area is access to data: in the mortgage market, lenders are required to collect and report data in accordance with the Home Mortgage Disclosure Act. No such requirement exists for private student loans. In fact, federal law generally prohibits lenders from collecting key information on pricing grids and the race or ethnicity of students.
Investigating abusive student lending practices needs to be part of the strategy for rebuilding economic opportunity in communities of color. Education is the best route to eroding class and race barriers, but private lenders are currently strengthening obstacles for minority and low-income students. Attempting to break a cycle of poverty is an audacious act - fair lending laws should protect the vulnerable students who brave this unlikely frontier.