A Borrower-Centered Plan For Student Loan Relief

We can help distressed student borrowers without giving excessive taxpayer subsidies to high-earning professionals.

Photo by Albany Capture on Unsplash

Executive Summary

With over 8 million borrowers in default on their student loans, some have called on the federal government to cancel all or most of the outstanding federal loan portfolio. But such a policy would benefit many high-earning professionals who do not need the assistance and fail to address the $1.1 trillion in new loans that the federal government will disburse over the coming decade.

This blueprint offers a fiscally responsible agenda to help student borrowers in financial distress, while limiting relief to upper-income debtors and holding colleges accountable for their students’ poor loan outcomes. The agenda is built around the following policies:

• Reduce administrative fees and seizures for borrowers in default on their loans, and create a clear pathway for defaulted borrowers to return to good standing.
• Simplify income-driven repayment plans and ensure that low-income borrowers will never face an unaffordable monthly payment.
• Guarantee that the 25 million borrowers who owe less than $20,000 will never “move backward” on their loans, so long as they make their payments on time.
• Penalize colleges where loan outcomes are poor, and limit excessive student lending in the future.

While borrowers should be responsible for the student loans they have taken out, the U.S. government’s irresponsible lending practices are complicit in the student loan default crisis. This borrower-centered plan for student loan relief will ask those who are able to repay their loans, while also ensuring that the repayment process is fair and manageable, and that colleges are held accountable for loan defaults going forward.

Introduction

Many have called for the incoming Biden administration to make student loan forgiveness a top priority. Some Democratic senators are pushing the President-elect to use his executive authority to cancel $50,000 in debt per borrower, at a cost of $1 trillion. Biden himself has signaled support for a narrower plan to forgive $10,000 per borrower. He has also expressed a desire to work with Congress on relief rather than act unilaterally.

According to a Pew Charitable Trusts poll, 81% of Americans say that the government should make it easier for student borrowers to pay back their loans. However, a majority (61%) also agree that borrowers should do more to make repaying their loans a priority. One may infer that the median American believes that borrowers should be responsible for paying their loans, but that the government must make it easier for them to do so.

Canceling all or most of the outstanding federal student loan portfolio is an expensive, irresponsible, and blunt solution to the problems facing student borrowers. At the same time, policymakers cannot continue to tolerate a status quo in the federal loan program that looks increasingly untenable, as loan defaults and taxpayer losses mount. This policy brief offers a fiscally responsible plan for student loan reform that will help student borrowers most in need and ensure that a large-scale loan crisis never happens again.

The Real Student Loan Crisis

According to the Brookings Institution, 27% of student loan borrowers go into default on their loans at some point. A borrower enters default when she fails to make a payment on her loan for 270 days straight. After default, the federal government, in partnership with private collections agencies, is authorized to pursue extraordinary measures to collect on the loan. Defaulted borrowers have their wages garnished and their tax refunds and Social Security benefits seized. In some cases, they must pay thousands of dollars in fees, in addition to whatever interest they accumulate while in default. The default can also hurt their credit score.

While the government should try to collect debts that are owed to taxpayers, many of the policies governing collections are overly punitive, and in some cases counterproductive. Layering on excessive fees could stop borrowers from attempting to pay the loan at all, while seizing tax refunds can deprive borrowers of money they need to keep their financial lives in order.

In addition to the negative consequences of default, borrowers who default tend to be in financial distress and are frequently dissatisfied with the education they used the loans to finance. Almost half (45%) of borrowers who earn less than $20,000 after leaving school default on their loans within four years, but the rate drops into single digits for those with incomes above $80,000.

Source: Yannelis (2020)

However, the best predictor of default is whether a student finishes college. Over three-quarters of student loan defaulters did not earn a degree, and 50% only attended college for a year or less. According to the Brookings Institution, at least 45% of college dropouts will default on their loans, compared to just 8% of college graduates.

While borrowers should be responsible for the debt they take on, the federal government is complicit in the dropout-default crisis. The Department of Education extended many of these students loans at age 18 with zero regard for their ability to repay. In fact, many of the low-value programs these students attended only exist because of federal grant and loan subsidies. When they failed to complete college, these borrowers were left with debt but none of the labor-market benefits of a college degree. Most of them defaulted on very small balances, having only attended college for a semester or two. More than six in ten borrowers in default owe less than $10,000, while the median college graduate owes $30,000.

Source: Looney (2018)

This phenomenon also explains why mass student loan forgiveness is misguided. Those with the highest balances tend to have the lowest default rates. High-balance borrowers normally finished college, and often earned an advanced degree as well. People with a graduate education will earn $1 million to $1.5 million more over their lifetimes than people with only a high school degree, meaning their student loans are usually an annoyance rather than a barrier to opportunity. While the lowest income quintile owes just 5% of all outstanding student debt, their loans tend to present a much bigger problem.

Some debt cancelation proposals limit forgiveness to a certain balance per borrower to address the regressivity issue. (President-elect Biden proposes $10,000.) That still doesn’t make forgiveness an optimal use of taxpayer dollars. Generally, government financial assistance should not be conditioned on arbitrary characteristics such as whether an individual has student loans. Student loan relief should be narrowly targeted to those whose financial distress is the result of student debt, which includes many defaulters. However, the student loan program is a poor vehicle to deliver general financial assistance to needy households. The poorest and least-educated Americans have no student loan debt at all.

Moreover, forgiveness encourages excessive borrowing going forward, since it carries the implicit promise of repeated debt jubilees. The federal government will make over $1 trillion in new loans over the next decade, and many of those loans will end up in default if policymakers allow the status quo to continue. Policies to help student borrowers today must go hand-in-hand with more fundamental reforms to the loan program, in order to head off another debt crisis down the road.

A responsible and sustainable student loan relief plan should accomplish three goals:

1. Target relief to borrowers most in need. Low-income borrowers, unsurprisingly, show the greatest signs of financial distress, such as delinquency and default. This group overlaps considerably with college dropouts, who are the least likely to pay back their loans. Most borrowers in financial distress have low balances.
2. Avoid spending on borrowers who don’t need the money. People who completed a college degree, or even a graduate degree, are unlikely to need financial assistance from the government. Moreover, high-education borrowers are disproportionately likely to access the loan program’s existing benefits already.
3. Stop the next student loan crisis before it happens. Student loan relief today can create a moral hazard, leading to higher borrowing down the road. Loan relief must go hand-in-hand with reforms to rein in the federal student loan program and hold low-quality colleges accountable going forward.

Unfortunately, mass loan forgiveness accomplishes only the first goal, while emphatically failing the second and even setting back progress at achieving the third.

What follows is a student loan relief agenda that will achieve all three goals. The plan helps borrowers most in need while asking those who are financially able to continue paying their loans. It introduces new accountability measures to curtail future student loan defaults and excessive borrowing, which will also offset much of the fiscal cost of relief for needy borrowers.

The agenda’s proposals that fall into three categories: helping people who are currently in default, making student debt more manageable, and reforming the student loan program going forward to avoid a future crisis.

How To Help People In Default Today

Over 8 million federal student loan borrowers are currently in default, while almost 100,000 borrowers enter default every single month. Over one quarter of undergraduate borrowers will default at least once over the lifetime of their loans, exposing them to serious consequences like wage garnishment and seizure of tax refunds. While some disincentives to loan default should be maintained, the current system is far too punitive and actively makes it harder for borrowers to get back on their feet. The federal government’s goal should not be to punish defaulted borrowers, but to help them start paying their loans again in a straightforward and manageable way. The following recommendations will help achieve that goal:

• Reduce punitive fees. When the government initiates wage garnishment against a defaulted borrower, it collects fees equivalent to 19.6% of each payment. The American Enterprise Institute estimates that these penalties can exceed $2,000 over the lifetime of a typical $7,000 loan. When a defaulted borrower’s Social Security benefit is seized, 11% of the payment goes to fees, on average. Fees are even collected when a borrower makes a voluntary payment on a defaulted loan. In addition to the financial consequences, these penalties drag out the collections process, add interest, and make it harder for the borrower to return to good standing. Rather than punitive fees that burden borrowers for years, the penalty for default should be a one-time $150 fee added to the balance at the point of default, with no further fees afterward.
• Don’t seize the Earned Income Tax Credit of defaulted borrowers. The U.S. Treasury Department seizes nearly $2.1 billion of federal tax refunds every year in order to pay borrowers’ defaulted loans. Unfortunately, antipoverty programs such as the Earned Income Tax Credit (EITC) are also distributed through the income tax system, meaning low-income student loan defaulters may have a critical financial lifeline taken away from them. The refundable portion of the EITC amounted to $56 billion in 2018, 85% of which went to families earning below $30,000. While the IRS should continue to seize income tax refunds for middle- and high-income defaulters, taking the EITC away from low-income families is a bridge too far. By definition, EITC-eligible defaulters are working, so most will repay their loans through wage garnishment eventually. Allowing them to keep EITC benefits for now is not a terribly costly mercy.
• Allow borrowers to resolve defaults quickly and easily. Currently, borrowers can exit default either by fully repaying their loans or returning them to good standing through a resolution process. However, resolution pathways are opaque and come with hidden requirements and fees. Instead, a defaulted borrower should be able to resolve her default simply by enrolling in any repayment plan available to borrowers in good standing. The borrower’s first payment after a resolution should instantly stop wage garnishment and other seizures. As an added incentive, the default should be cleared from the borrower’s credit record after she enters resolution and makes six on-time payments. This will benefit both the borrower and the federal government, which will no longer need to initiate costly collections proceedings such as wage garnishment in order to collect defaulted loans.

Once borrowers are out of default, the government will need to ensure that their monthly payments are manageable, so they do not slip back into the red.

How To Make Student Debt More Manageable

Borrowers usually default because they cannot afford their monthly loan payments. Fortunately, the federal government already offers benefits to reduce monthly payments to a manageable level. The lowest-income borrowers even qualify for a zero payment. However, the complexity and bureaucracy surrounding these benefits often make them difficult for borrowers to access. The following recommendations will help borrowers take advantage of existing benefits, and introduce new benefits to assist lower-income debtors:

• Ensure borrowers know what benefits are available to them. The median student borrower who earns less than $20,000 faces a loan payment exceeding 10% of income. But under income-driven repayment (IDR) plans, almost all of these borrowers should qualify for a $0 monthly payment. This suggests a major problem is awareness. According to the National Postsecondary Student Aid Study, just 43% of undergraduate borrowers know that IDR plans exist. A massive public-awareness campaign by the Department of Education should boost borrower knowledge of these benefits, leading to more manageable payments and fewer defaults. Evidence shows that IDR take-up significantly reduces student loan default rates, and expanded IDR enrollment would benefit people below median income most of all. The awareness campaign should also remind borrowers to recertify their IDR enrollment every year, as is required to continue participating in the program.
• Simplify repayment plans. The federal loan program offers five different income-driven repayment plans with varying benefits and eligibility restrictions, in addition to the standard non-income base- plan and its variations. The program will become far easier to navigate if the number of plans is reduced to two going forward: 1) a standard plan that offers level payments over a 10- to 25-year period (depending on balance size), and 2) an income-driven plan modeled on the current REPAYE plan, which sets payments at 10% of a borrower’s discretionary income and offers forgiveness of remaining balances after 20 years (for undergraduates) or 25 years (for graduate students).
• Accelerate forgiveness for low-balance borrowers. IDR is always a better option than default for struggling borrowers. Even if a borrower’s monthly payment is set to $0 under IDR, she will still make progress toward loan forgiveness at the end of the repayment cycle. But the long time period involved (20 years in most cases) can make the benefits of IDR seem remote. Therefore, for the 15 million borrowers who owe less than $10,000, forgiveness should be accelerated to 10 years instead of 20. IDR enrollees with balances below $10,000 will see forgiveness within a decade, while those with higher balances will see their remaining time to forgiveness cut to 10 years once they hit the $10,000 mark. Under income-driven plans, even borrowers with modest earnings typically pay off a $10,000 loan within 10 years, so this provision will only benefit borrowers with persistently low incomes.
• Guarantee interest payments for low-income borrowers. Another psychological barrier for IDR enrollees is negative amortization. If a borrower’s IDR payment does not cover the interest on her loan, her outstanding balance will climb. Even though much of that will eventually be forgiven, a growing balance can cause a frustrated borrower to give up on paying the loan altogether. To that end, if a borrower is enrolled in IDR and making payments that do not cover the interest on a $20,000 student loan, the government should step in and make up the difference. For instance, if a borrower’s outstanding debt is $20,000, monthly accumulated interest is $80, and the borrower’s IDR payment is only $50, then the government would pay the remaining $30. This will prevent the 25 million borrowers who owe less than $20,000 from ever “moving backward” on their loans. Since the design of IDR means that only low-income borrowers will fail to cover interest on a $20,000 loan, this interest subsidy will phase out to $0 as income rises. Using data from the Survey of Consumer Finances, I estimate that this provision would cost roughly $6 billion per year, but almost all of that spending would benefit borrowers below median income.¹

The latter two provisions — accelerated forgiveness and guaranteed interest — could be implemented automatically by loan servicers, with no need for borrowers to fill out extra forms. Therefore, they will not increase the complexity of the loan program from the borrower’s perspective. They will, however, reduce government revenue from loan payments. Fortunately, stronger accountability rules for colleges and other changes to the loan program can offset some of the cost.

How To Avoid Another Student Loan Crisis

The above policies will be rather pointless, in the long run, if Congress does not simultaneously undertake more comprehensive reforms to federal student lending in order to prevent another student loan crisis in the future. Two considerations should guide student loan reform: the federal government should stop making loans that are likely to end up in default, and should also make smaller loans in general. The following reforms will help accomplish these goals and offset some of the cost of the other provisions:

• Penalize colleges where students experience poor loan outcomes. Two of the top predictors of default are college completion and borrower income. If colleges are held accountable for their students’ loan outcomes after leaving school, they will have a much stronger incentive to ensure their students both finish college and can use their education to secure comfortable jobs. To that end, colleges which participate in the federal loan program should be assessed a $1,000 penalty for every student who 1) defaults on their loans within five years of entering repayment, 2) is at least ninety days delinquent on their loans five years after entering repayment, 3) has a higher balance five years after entering repayment than they did upon leaving college, or 4) requires interest subsidies on their loans for at least 30 of the first 60 months of the repayment cycle.
• Use revenues to offset the cost of other provisions. For the borrower cohort entering repayment in 2012, 2.75 million borrowers either defaulted on their loans or saw their balances increase within five years of leaving school. If the penalty system were in place for the 2012 cohort, the federal government would have raised at least $2.75 billion, offsetting about half the cost of the new IDR interest subsidy. If the penalty induces colleges to change their behavior in order to ensure more of their students succeed, direct revenue from this provision will be lower. However, the government’s fiscal position will improve if the penalty discourages colleges from offering low-value education, since fewer federal student loans will end up in default, delinquency, or severe negative amortization.²
• Eliminate Grad PLUS and Parent PLUS loans. The federal Grad PLUS program extends effectively unlimited credit to graduate students. Thanks to IDR, about 72% of Grad PLUS disbursements over the coming decade will eventually be forgiven. This has resulted in a proliferation of low-value programs at the graduate level, with significant cost to taxpayers. Eliminating Grad PLUS will save taxpayers $37 billion over the coming decade, according to the Congressional Budget Office’s fair-value estimates. Parent PLUS, another effectively unlimited loan program for parents of undergraduate students, frequently loads parents up with high-interest debt that they may have little ability to repay. After all, parents do not receive the earnings benefits of their children’s education. Though Parent PLUS is a moneymaker for the federal government, pegged to bring in $15 billion over the next decade, the cost of ending it will be more than offset by the savings from eliminating Grad PLUS.

Conclusion

It’s possible to help distressed student borrowers without delivering excessive taxpayer subsidies to high-earning professionals with graduate degrees. The plan described in this brief offers a clear path for defaulted borrowers to return to good standing without incurring excessive penalties. Fifteen million student borrowers with balances below $10,000, who include 61% of defaulters, will have access to accelerated loan forgiveness under IDR. Twenty-five million borrowers with balances below $20,000, who represent more than half of federal borrowers, will never see their balances rise as long as they remain in good standing. To offset the costs of these provisions, colleges will be held accountable when their students fail to repay their loans.

The policies recommended in this brief should not preclude the possibility of comprehensive long-term reforms to student lending, including full risk-sharing for colleges or replacing the federal loan program with a national income-share agreement repaid through the income tax system. Rather, they are shovel-ready policies that are both backward- and forward-looking: both current and future borrowers will benefit. Policymakers can help students emerge from default, ensure monthly payments are affordable, and avert a future default crisis by holding colleges accountable for student outcomes, all for a fraction of the cost of mass student loan forgiveness.

Endnotes

1. The Survey of Consumer Finances tends to underestimate student debt held by households. To arrive at the $6 billion cost estimate, I calculate the annual cost of the interest subsidy as a share of total outstanding federal education debt held by non-student SCF respondents, which is equal to 0.46%. I then multiply this percentage by total outstanding debt held by borrowers not in school, as reported in Department of Education administrative data (approximately $1.4 trillion in September 2020). The result is an estimated annual cost of $6.3 billion.
2. The Center for American Progress has released a dataset of five-year loan outcomes for the 2012 repayment cohort. I merge this dataset to institution-level repayment rates from the College Scorecard, which report the share of nondefaulted borrowers who have paid down at least $1 of their loans within five years of entering repayment. I add the number of defaulted borrowers to the number of nondefaulted borrowers who have not made progress paying down their loans to estimate the total number of “bad-state” borrowers for the 2012 cohort. I ignore borrowers who are more than 90 days delinquent, as well as borrowers who defaulted and then recovered, on the assumption that all of them are also not making progress on their loans. This assumption should lead to a slight underestimate of the number of “bad-state” borrowers, and therefore a slight underestimate of penalty revenues.