In the United States, about one in three students enrolled in a bachelor’s degree program eventually drops out. The stock of student loans held by these dropouts is sizable. We establish empirically that college students and their parents are overly optimistic about the probability of college graduation when making college enrollment decisions. We incorporate such over-optimism into an overlapping generations model, which also includes family transfers, federal student loans, and a private student loan market. We discipline these model attributes using panel data from the U.S. Bureau of Labor Statistics and the U.S. Department of Education, and then examine the impact of over-optimism and of expanding federal student loan limits in the presence of over-optimism. We find that over-optimism, despite reflecting mistaken beliefs, increases welfare for 18-year-olds as a result of equilibrium adjustments in income taxes, family transfers, and skill. Expanding federal student loan limits reduces welfare for low-skill 18-year-olds from poor families, a result driven by the presence of over-optimism.