For Student-Loan Borrowers, Good Credit Where It's Due.

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Author: Gross, Karen1,2

More than 40 percent of college graduates now leave their campuses owing over $20,000 in student loans. Among those earning doctoral degrees, more than 60 percent finish their education with over $30,000 in student-loan debt. For medical- and law-school graduates, the figures are higher still.

The most recent data available from the State Public Interest Research Groups' Higher Education Project suggest that 39 percent of student borrowers leave academe with unmanageable debt -- assuming, as many lenders and credit experts do, that student-loan payments in excess of 8 percent of monthly income are unmanageable. And having large debts for education means that you have a harder time borrowing for other purposes, like a mortgage, and that you pay higher interest rates when you can take out new loans.

Student-loan debts are related to deep problems in our society -- for example, limited access to higher education for the less affluent -- that cannot be solved without complex changes. But we can reduce the debts' impact through a relatively simple, quick, and inexpensive reform: changing our credit-scoring system.

Your credit score determines how much you pay when you borrow money: The lower the score, the higher the price of credit. A low score can also affect your ability to buy insurance for property or a home at a reasonable rate because insurance companies assume that you are a risk taker and under financial stress, and thus may be unreliable in making payments. A poor score might even hurt your chances in the job market, as some employers think that people with credit problems might help themselves to the company's money to pay off personal debts.

But details about what variables make up the score, how they are weighted, and how they affect each other are information that the companies that calculate and report credit scores have never made public.

The first step toward reform is for the companies to reveal precisely how they determine the scores. The companies view scoring models as proprietary data, but they could at least disclose the information to a federal entity like the Federal Reserve Board. The Fed -- which is charged with overseeing our nation's monetary policy, including the cost and availability of credit -- has the expertise and objectivity to assess the fairness of the scoring models and to oversee the companies that use them.

The next step is to change how the companies treat student loans in their models. From the information that is available -- including data from the leading credit-score company, Fair Isaac -- we can safely assume that for scoring purposes, the companies treat student loans like mortgages or credit-card debt. That approach means that recent graduates with overwhelming debt or a single default on a large student loan will have very poor credit scores, which doom them to higher prices for credit after they graduate.

Yet companies like Fair Isaac do rank certain forms of debt as better or worse. For example, borrowing from a finance company is less creditworthy than borrowing from a major bank. The rationale is that banks are better than finance companies at evaluating the risk of lending to potential borrowers, and thus those who get loans from banks are more likely to repay the money.

Why not treat student loans as better than other debts? Big student loans are in large part the result of the cost of education, not the spending habits of the student -- and thus not a good indication that the borrower is a poor credit risk and likely to default.

In addition, the product of student borrowing is an asset that increases the student's economic value: education. That is quite different from using a credit card to take a vacation or to buy chips at a casino.

Another desirable change would be to give additional scoring benefits to those who have good repayment records with their student loans. Private lenders who make guaranteed student loans have historically been less aggressive than other lenders about collecting debts. So borrowers who consistently make timely payments on student loans are probably doing so without special pressure from lenders, and are likely to have the money to pay their other bills, too. Thus they should receive an improved credit score.

Such a system of rewards is not as far-fetched as it might appear. A new company in the scoring industry -- Pay Rent, Build Credit -- has developed a model that gives certain consumer payments more positive points than other payments. For instance, payments on student loans, child-care expenses, business loans, and credit-card debt have the same high rank, but payments for parking, utilities, and self-storage facilities rank lower. The model recognizes that some payments -- like those that reduce credit-card debt, with its burden of very high interest rates -- tell more than others about a person's financial stability and risk of default. And the model reflects the values of our society, which considers child care far more important than parking.

We also need to treat defaults on student loans differently in credit scores. Obviously, repeated missed payments are a problem. But missing a single student-loan payment does not signal the same financial distress as not keeping up with mortgage payments, for example. And given the laxity of some collection of debt for private student loans, as well as the many opportunities for revamping student debt through consolidation, deferment, or forbearance, an occasional late student-loan payment is not necessarily an accurate predictor of the borrower's creditworthiness -- which is, after all, what the credit score is supposed to measure.

Moreover, it appears that current models of calculating scores give a better rating to borrowers who have consolidated their student loans. That suggests that students who stick to the original terms of their loans -- usually paying off the money over a shorter time and at higher interest rates -- are considered relatively less creditworthy, a result that makes little sense.

Yet another useful reform would be to improve the way lenders report information about student loans to credit-reporting agencies, which in turn provide data to credit-score companies. Currently each loan is reported as a separate item instead of being aggregated with other student loans from the same lender. Moreover, when loans are resold, as they frequently are, a loan is often reported twice -- once with the name of the original lender, and once with the name of the new lender. That makes it easy for companies to mistake the true amount of debt and to miscalculate the borrower's credit score.

Other changes might be obvious if we knew how the models worked. In any case, we should do whatever we can to avoid penalizing Americans who borrow for education, as opposed to, say, buying a new car or plasma television.

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By Karen Gross

Karen Gross is a professor of law at New York Law School and president of the Coalition for Consumer Bankruptcy Debtor Education.