A recent report from the American Enterprise Institute, titled Looking Backward or Looking Forward? Exploring the Private Student Loan Market, analyzes student loan practices by private lending companies.  It analyzes the current criteria for loan qualification, and offers insight on new potential criteria that may improve the performance of private lending companies.

For those who do not know, a credit score is a numerical grade on an individual’s past credit practices; basically, higher scores mean a good history of spending with a credit card and paying the spending balance on time.  In the consumer lending market, credit scores are popular tools due to their accessibility; additionally, they have been proven to be highly correlated with borrower behavior.  Overall, credit scores are universally accepted and legal underwriting criteria, and they serve as the basis for consumer lending.

Many private student loan lenders determine a borrowers eligibility based on a credit score, but there are key differences between a student loan and car or mortgage loan. One difference is that applicants for student loans generally do not have an established credit score like a potential mortgage borrower.  This leads to the need for a cosigner in the majority of education lending situations which may unnecessarily tie in parents to a student loan.  Those with low credit scores and no co-signer are essentially barred from receiving private financial aid.

Another difference is collateral.  Defaulting payments on an auto loan leave the lender with a car to earn a return on a loan, but student loans lack this collateral because lender cannot take back an education on a defaulted student loan.

While this seems like a reason not to invest in a student’s education, the average student still benefits economically from investing in education, but using only creditworthiness as criteria for loan qualification leaves out a large pool of candidates (from low-income origins) despite an average positive return from investing on a degree

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A targeted approach known as “forward-looking underwriting” determines a borrower’s qualifications based on more factors than just credit history (considered backward looking).  Forward looking analyzes the potential future earnings in order to determine the strength of a student loan; conversely, backward looking decisions  are often made based off of a co-signers current standing instead of the student’s future standing.  Backward looking can lead to investments that may never generate a positive return; additionally, this can lead to an oversupply of these cases with weak financial investments.

A reconsideration of the student loan qualification process may lead to better investment decisions in the future.  Through data analysis and estimates of future earnings, a tailored loan can be given with a much better likelihood of a positive return.  This forward looking underwriting method may trump the traditional backward looking underwriting method and provide educated and calculated loans based off future circumstances.

While this method sounds like a great solution, there are so many other factors to consider such as tuition and overall cost of education.  Here is just one example:  If student loans are going to be tailored based on the return of a certain education, then tuition would need to be tailored the same way for this to be 100% effective.  The cost of tuition is just another issue in the fight to finance higher education, but more educated forward looking investments may be an answer to a growing problem.