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The Interplay Between Student Loans and Credit Cards: Implications for Default

  • Felicia Ionescu

    ()

    (Colgate University)

  • Marius Ionescu

    ()

    (Colgate University)

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    We analyze, theoretically and quantitatively, the interactions between two different forms of unsecured credit and their implications for default behavior of young U.S. households. One type of credit mimics credit cards in the U.S. and the default option resembles a bankruptcy filing under Chapter 7 and the other type of credit mimics student loans in the U.S. and the default option resembles Chapter 13 of the U.S. Bankruptcy Code. In the credit card market financial intermediary offers a menu of interest rates based on individual default risk, whereas in the student loan market the government sets a fix interest rate. We prove the existence of a steady-state equilibrium and characterize the circumstances under which a household defaults on each of these loans. We demonstrate that the institutional differences between the two markets make borrowers prefer default on student loans rather than on credit card debt. Our quantitative analysis shows that the increase in college debt together with the changes in the credit card market fully explain the increase in the default rate for student loans in recent years. While having credit card debt increases student loan default, loose credit card markets help borrowers with large student loans smooth out consumption and reduce student loan default. We find that the recent 2010 reform on income-based repayment on student loans is justified on welfare grounds, and in particular, in an economy with tight credit card markets.

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    File URL: http://humcap.uchicago.edu/RePEc/hka/wpaper/Ionescu_Ionescu_2012_interplay-student-loans-credit.pdf
    File Function: First version, 7/13/2012
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    Paper provided by Human Capital and Economic Opportunity Working Group in its series Working Papers with number 2012-014.

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    Date of creation: Jul 2012
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    Handle: RePEc:hka:wpaper:2012-014
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    1. Ionescu, Felicia & Simpson, Nicole, 2010. "Credit Scores and College Investment," Working Papers 2010-07, Department of Economics, Colgate University.
    2. Chatterjee, Satyajit & Corbae, Dean & Ríos-Rull, José-Víctor, 2008. "A finite-life private-information theory of unsecured consumer debt," Journal of Economic Theory, Elsevier, vol. 142(1), pages 149-177, September.
    3. Satyajit Chatterjee & Dean Corbae & Makoto Nakajima & Jose-Victor Rios-Rull, 2007. "A quantitative theory of unsecured consumer credit with risk of default," Working Papers 07-16, Federal Reserve Bank of Philadelphia.
    4. Athreya, Kartik & Tam, Xuan S. & Young, Eric R., 2009. "Unsecured credit markets are not insurance markets," Journal of Monetary Economics, Elsevier, vol. 56(1), pages 83-103, January.
    5. Igor Livshits & James MacGee & Michele Tertilt, 2003. "Consumer bankruptcy: a fresh start," Working Papers 617, Federal Reserve Bank of Minneapolis.
    6. Athreya, Kartik B., 2002. "Welfare implications of the Bankruptcy Reform Act of 1999," Journal of Monetary Economics, Elsevier, vol. 49(8), pages 1567-1595, November.
    7. Huggett, Mark, 1993. "The risk-free rate in heterogeneous-agent incomplete-insurance economies," Journal of Economic Dynamics and Control, Elsevier, vol. 17(5-6), pages 953-969.
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