Strategic Default on Student Loans

Journal of Finance, R&R
Best Paper Award, FMA Napa Conference on Financial Markets Research 2017

Student loans finance investments in human capital. Incentive problems arising from lack of collateral in human capital investments have been used to justify the differential bankruptcy and other recovery treatment of student loans, despite a lack of empirical evidence of strategic behavior on the part of student borrowers. This paper uses policy induced variation in non-repayment costs, that is unrelated to liquidity, to test for a strategic component to the non-repayment decision. The removal of bankruptcy protection and increases in wage garnishment reduce borrowers’ incentives to default, providing evidence for a strategic model of non-repayment. The results suggest that rein- troducing bankruptcy protection would increase loan default by 18%, and eliminating administrative wage garnishment would increase default by 50%. Consistent with strategic behavior on the part of borrowers, the incentive effects of bankruptcy are larger for borrowers with large balances, and smaller for very low and high income borrowers. The results provide novel evidence that strategic behavior plays an important role in student loan repayment.