The Hidden Costs Inside Biden’s Student Loan Bailout
President Biden’s income-based repayment expansion may prove even more expensive than loan forgiveness.
President Biden’s announcement that he would forgive up to $20,000 in student debt per federal borrower grabbed headlines last week. Another component of the same announcement — the expansion of income-based repayment (IBR) plans for borrowers going forward — flew under the radar. But in the long run, the IBR expansion could be just as costly and consequential as the one-off debt cancellation.
Despite the fiscal scale of the announcement (independent analysts believe the whole package could cost more than $1 trillion), neither loan forgiveness nor the new IBR plan will solve any of the major problems in the student loan system. As colleges react to these generous new subsidies by raising tuition, political pressure for further giveaways will intensify. Serious reforms are necessary to salvage what remains of the student loan program.
Details of the new IBR plan
Income-based repayment has existed in one form or another since the 1990s, but the program has only become popular in the last decade. Instead of making set “mortgage-style” payments based on their loan balance, borrowers in IBR plans pay a set proportion of their income above some threshold. Under the most generous IBR plan in existence today, borrowers pay 10 percent of any income they earn beyond 150 percent of the poverty line. If any balance remains after 20 years of IBR payments, it is forgiven.
For example, a borrower in a two-person household earning $40,000 per year pays 10 percent of the difference between his income and 150 percent of the poverty line for two-person households ($27,465 in 2022). This amounts to $1,253 per year or $104 per month. This is already a significant reduction from the scheduled monthly payment under the standard “mortgage-style” plan, which is $318 for borrowers with the typical undergraduate debt load of $30,000.
Thanks to these benefits, IBR has exploded in popularity since it was created. Eight million people used IBR before the pause on student loan payments began in March 2020, and over half of direct loan balances in repayment were enrolled in an IBR plan. While the plans were originally intended as a safety net for low-income people, the Education Department has made them so generous that borrowers from across the economic spectrum now take advantage of them. The administration’s newest plan will make IBR even more attractive.
The new IBR plan raises the earnings exemption from 150 percent to 225 percent of the poverty line. Borrowers who earn above this threshold will pay 5 percent of their discretionary income rather than 10 percent. Moreover, the plan will forgive unpaid interest that accrues on a monthly basis. People who borrow less than $12,000 will receive forgiveness after 10 years rather than 20. Only undergraduate loans will be eligible for the new plan, though borrowers with graduate education can still enjoy the lower monthly payments on their undergraduate loans.
For most borrowers, these new terms will slash monthly loan payments by half or more. Going back to the borrower in the earlier example earning $40,000, the new income exemption is equal to 225 percent of the poverty line for two-person households, or $41,198. Since the exemption is higher than his income, this borrower’s annual payments will drop from $1,253 to $0 under the new plan.
Borrowers in higher income strata will also benefit. A typical borrower earning $65,000 will see payments drop from $3,754 to $1,190. Even borrowers earning six figures will see some reduction in payments.
Researchers at the University of Pennsylvania figure that the new IBR plan will cost $70 billion over ten years if borrowers do not change their behavior. But if these more generous terms lead to higher enrollment in IBR and greater borrowing in the future, the cost of the plan could balloon to $520 billion. That is roughly equivalent to the estimated cost of President Biden’s one-off loan cancellation this summer.
The cost of the whole package, therefore, could exceed $1 trillion. The Committee for a Responsible Federal Budget thinks it could increase inflation by 0.3 percentage points, which sounds small but equates to hundreds of dollars per year in additional costs for the typical American household.
How the new IBR plan will affect typical borrowers
The enormous cost of the plan makes sense when considering just how generous the new terms are. For many borrowers, payments will be so low that their debts can hardly be called “loans” at all. “Backdoor free college” might be a more apt description. A few examples of typical borrowers indicate how total loan payments will change, and sometimes disappear entirely, under the new system.
Example: Four-year college graduate, typical ROI degree
Consider a typical borrower who owes $30,000 to the federal government when he graduates college. He lands a job with a starting salary of $45,000, which is the norm for majors with a moderately positive return on investment such as business administration. His salary rises at a rapid clip and reaches $80,000 by mid-career.
If this borrower chooses an IBR plan under the current system, he will make $34,000 worth of payments in present value terms, paying off his $30,000 debt with interest. He will retire his debts 13 years after entering repayment.
But Biden’s new IBR plan will slash this borrower’s monthly payments. The good news (for him) is that he will pay just $22,000 over the lifetime of the loan, several thousand dollars less than he originally borrowed. But the lower monthly payments will keep him in repayment for far longer; in fact, his monthly payments will be insufficient to cover interest for the first ten years of the loan. He will keep paying his loans for 20 years, at which point the government will discharge his remaining balance.
The far slower rate of repayment under the Biden IBR plan means that many middle-income borrowers who would have fully repaid their loans under the current system instead stay in repayment for decades. Because the remaining balances are eventually forgiven, these students could borrow more at zero marginal cost. Any additional borrowing will simply be tacked on to the amount forgiven at the end.
Example: Four-year college graduate, low ROI degree
Borrowers who choose majors with a lower return on investment will enjoy even larger benefits from the Biden plan. Consider another borrower who also owes $30,000 but earns a much lower starting salary of $30,000. (This is typical for popular low-ROI majors such as English literature and psychology.) This borrower’s salary rises to $52,000 by mid-career.
Under the current system, this borrower makes $29,000 worth of payments over the lifetime of her loan. She still receives forgiveness at the 20-year mark, but her cumulative payments come close to the amount of her original balance. The borrower receives a subsidy from taxpayers on her loans, but it is not overwhelming.
That changes under Biden’s proposal. The new IBR plan slashes her payments to less than $25 per month. It is never enough to cover accrued interest, which is forgiven. However, her balance remains stuck at $30,000 despite two decades’ worth of payments. The full amount is forgiven at the end of the 20-year term. In total, this borrower repays less than $4,000 of her original $30,000 balance.
The modest subsidy that this borrower receives under the current system explodes. Under the new IBR plan, the government almost fully covers the cost of her loans. Total payments fall by almost 90 percent, bringing this borrower very close to federally subsidized backdoor free college. However, from the borrower’s perspective it may not feel like it: on paper, she will carry a $30,000 loan balance for 20 years.
Example: Community college graduate
Few community college students borrow under the current system. That may change under Biden’s new IBR plan, as nonborrowers will be leaving money on the table.
Consider a borrower who owes $10,000 when he completes a two-year degree at a community college. At a starting salary of $30,000, under the most generous IBR plan today he will make $11,000 worth of payments and retire his debt after 11 years.
The Biden plan will cut his total payments to less than $1,000. In some years, he will not make payments at all. The borrower will remain in repayment for ten years — never once making a debt in principal — and have his remaining balance cancelled. The upshot is that the portion of his community college education funded by loans will be more than 90 percent subsidized by taxpayers.
Community college is one of the few arenas of higher education where debt is not a major financing tool; just 17 percent of community college students borrow. But the new IBR plan means that community college students can get essentially free money by taking out a loan. Though community colleges have done a decent job keeping tuition down in recent years, that may change if federal loans become a larger part of their funding.
How the new IBR plan will change higher education
Income-based repayment plans have the advantage of ensuring that borrowers’ payments are capped at a reasonable share of their earnings. But they also decouple payments from the amount borrowed, meaning students may bear little to none of the cost of additional borrowing. The result is an erosion of price sensitivity that makes it easier for colleges to hike tuition. This was a problem even before the latest iteration of IBR. The new plan also further skews federal funding towards traditional four-year colleges over alternatives.
Reducing price sensitivity
Previous IBR plans decoupled balances and payments. The new one completely severs their relationship. Students who earn a bachelor’s degree with a standard return on investment will pay back only a fraction of what they originally borrowed. Students who choose lower-ROI majors will hardly pay back anything at all.
Unless she chooses an extremely lucrative major, a student would be a fool not to borrow the maximum loan she is eligible for. The average student will see a large chunk of her balance forgiven, and a significant share of students will see almost all their loans forgiven.
Colleges are sure to point this fact out to students as a justification for the loan-heavy aid packages they will inevitably offer. A greater willingness to borrow will lead to higher tuition as colleges pass more costs onto taxpayers. There is precedent: Law schools exploit existing loan forgiveness programs to push higher tuition through federally subsidized loans. The new IBR plan ensures that this scheme will spread to the undergraduate level.
There is a critical difference, though: Unlike federal loans to graduate students, loans to undergraduates are capped at $31,000 for dependent students and $57,500 for independents. (It is unclear whether Parent PLUS loans, which offer an unlimited line of credit to parents of undergraduates, will be eligible for the new IBR plan.) Many undergraduates are already borrowing at the limit.
However, the new IBR plan may have a major impact on borrowing on the extensive margin, turning nonborrowers into borrowers. Remarkably, 45 percent of undergraduates do not take out loans. These students may think they’re being responsible, but under the new system they would be leaving money on the table. A new willingness to borrow among this group would reduce sensitivity to price. The result will be upward pressure on tuition.
Fueling credential inflation
The new IBR plan also puts a thumb on the scales in favor of traditional four-year colleges. Students can maximize the subsidy they get from the federal government if they take out more loans. Suddenly, it might make more financial sense to attend an expensive private university rather than a community college or a trade school. Traditional colleges already enjoy an enormous funding advantage relative to alternatives, and the new IBR plan will only multiply it. This dynamic will fuel credential inflation — as more students pursue a bachelor’s degree, employers will ratchet up their education requirements and further restrict opportunities for people without a college degree.
Thankfully, loans to graduate students will not be eligible for the new IBR plan. But graduate borrowers can still use the plan to repay their undergraduate loans, so the new subsidy will have an indirect effect on willingness to borrow for graduate school. The plan will provide further fuel for a bubble in low-quality master’s degrees that further engenders credential inflation at the graduate level.
Most ironically, the new IBR plan doesn’t even solve federal student loans’ biggest image problem. Many borrowers complain of making payments year after year, yet never seeing their balances drop; the promise of future forgiveness is cold comfort to people watching interest charges rack up. But the exceedingly low payments under the new IBR plan will be insufficient to cover interest for millions of borrowers. While the government will forgive unpaid interest every month, these borrowers still won’t make a dent in principal. They will make payments year after year, yet some will never see their balance drop by one penny.
In theory, this shouldn’t matter: Any unpaid balances will be cancelled after 10 or 20 years, so a balance that fails to decline is no big deal. But even though total payments will go down significantly, those high balances will remain a psychological burden for borrowers. Slower repayment rates also mean aggregate student debt rises at a faster clip, feeding the “student loan crisis” narrative. Political pressure for further rounds of loan cancellation is not likely to abate; in fact, it could intensify.
Fixing income-based repayment to align cost with value
President Biden’s new income-based repayment plan was enacted without congressional authorization, but there’s no reason Congress can’t reassert its authority over the terms of IBR plans. Congress could restore an older version of IBR, returning the income-share rate to 10 percent and the exemption to 150 percent of the poverty level. Lawmakers could also vary the terms of IBR plans with the borrower’s original balance, asking borrowers with larger balances to remain in repayment for longer. That way, students get an affordable payment that still leaves them at least somewhat sensitive to the amount they borrow.
But the genie may be out of the bottle. Congress may find it difficult to take away the more generous IBR terms introduced by the Biden administration. If the new IBR plan is here to stay, there are still options to rein in its fiscal impact.
Rather than increasing monthly payments, Congress could control the costs of IBR by defunding degree and certificate programs where graduates’ earnings are not aligned with costs. If students’ loan payments under IBR are insufficient to make a meaningful dent in principal, their programs should no longer be eligible for federal student aid funding — or at the very least, the programs should be required to repay the portion of the balance that students cannot. For instance, if a cohort of graduates five years after entering repayment is not on track to fully repay their loans within twenty years, that program should face either financial penalties or termination from federal aid.
Low-return programs that end up being heavily subsidized by taxpayers through IBR would no longer receive federal loan funding, significantly reducing the cost of the new IBR plan. To be eligible for continued loan funding, schools would need to enroll students in higher-return programs which enable them to repay all or most of their debts, even under the new IBR plan’s more generous terms. (Alternatively, schools could cut their prices.) Taxpayer savings are only part of the benefit. Students would also enjoy higher-paying careers — or at the very least, lower tuition.
It’s important not to sugarcoat this: The new IBR plan is so generous that even students in popular medium-ROI majors such as business might not fully repay their debts. If the standard for continued participation in aid programs is that students must be on track to fully repay their loans within twenty years, some programs with modestly positive financial returns might not make the cut. But if Congress and the Biden administration determine that an affordable student loan payment is no more than 5 percent of income above 225 percent of the poverty line, then the government cannot in good conscience continue to fund programs where payments at that level are insufficient to fully pay off the loan.
Under this proposal, colleges must either lower their prices or offer degrees with higher returns in order to enjoy unfettered access to the tens of billions of dollars that the federal government distributes in student aid every single year. Expanding income-based repayment could cost taxpayers up to half a trillion dollars, and much of the benefit will flow to institutions of higher education. It’s time to make sure they deserve it.
