Student Loans: When is Risk Sharing Desirable?

Abstract

In higher education, pure credit market funding leads to underinvestment due to insufficient risk pooling, while pure income-contingent loan funding leads to overinvestment. We analyze whether funding diversity – a market structure in which credit markets coexist alongside income-contingent loan funding – might restore efficiency of the educational investment process. In the absence of government intervention, we find that funding diversity improves pooling of individual income risks and, under some condition, leads to higher social welfare than pure credit market funding. If combined with a policy that restricts access to higher education, funding diversity even achieves full investment efficiency and strictly dominates credit market funding.