A Better Student Loan Fix

It’s critical to reduce reliance on loans now and in the future.

Student loans are a prime example of a well-intended public policy that ran smack dab into the law of unintended consequences. On the one hand, loans have enabled tens of millions of students to go to college, earn a degree and go on to successful careers. Many other millions, though, have acquired crushing debts that have made them wary to marry, buy a home or simply enjoy the kind of life they envisioned. Nearly everyone agrees that the student loan system needs to be fixed, but how?

President Biden has offered two big ideas. One would have forgiven up to $20,000 in debt for 20 million borrowers or more. The Supreme Court in June struck down that plan, but officials in the administration have not given up; they have announced a work-around that it claims will pass Court scrutiny. Meanwhile, Biden’s second plan is being implemented. It would lower repayment obligations for many millions of borrowers based on their income after-graduation. Together, these plans would save borrowers — but cost taxpayers — at least $500 billion over the next ten years.

Who Owes What? Here is what’s at stake: About half of the country’s 45 million student borrowers owe no more than $20,000, Biden’s proposed upper limit of debt relief. Experience suggests most of them will be able to repay on schedule. But although less than one-tenth of debtors owe at least $100,000 or more, their loans amount to one-third of the total.

The Biden debt cancellation plan would cost $300 billion or more over the next ten years. It provides the most relief to the borrowers who owe the least or those who have the best chance of fully repaying their loans. On the other hand, most of those struggling with six-figure student debt would get relief for only a small portion of their obligations.

The other part of the administration’s plan — revising loan repayment schedules based on borrowers’ income- — would indeed make repayment easier for millions of borrowers. But much of its price tag of at least $200 billion would offer the most help to those who need it the least. The plan is simply too generous. Plus, reducing the cost of borrowing so drastically would do little to lower college costs or reduce borrowing in the future. In fact, these plans are likely to fuel tuition increases by encouraging even borrowing to pay for college in the future.

What is needed, instead, are cost-effective ways to provide relief to borrowers who truly need it or deserve it, plus reforms that will sharply reduce reliance on student loans in the future.

Dealing with Current Debt: Four Reform Components. When it comes time to repay, student borrowers now face multiple options with a bewildering set of terms and conditions that are confusing and costly to government and borrowers alike. Rather than try to modify the terms and conditions of these loans one at a time, I propose a revamped loan system with four parts.

The first step would be to set up an independent counseling network to help all borrowers understand their repayment options. Next, the federal government should buy up privately-held loans that have little prospect of repayment. Third, remaining debt should be forgiven for those who got ripped off by questionable schools because the government failed to perform its due diligence when it dubbed them qualified to participate in federal student aid programs including loans. Finally, all student borrowers should be allowed to refinance all their existing loans into a single income-contingent note at reasonable cost to the borrower AND taxpayer.

Each part of the plan outlined above requires legislation. But no part of it is dependent on any other part and enacting any element would be a big improvement over the current system.

1. Provide better debt counseling for all borrowers. The government should fund a network of independent student loan counselors online and in various locales so that every borrower can work out an individualized repayment plan. Counselors can identify options that provide relief for borrowers having trouble making their payments. The costs of creating these counseling networks would be modest relative to the costs of default and nonpayment, while the benefits would be large if a wide range of borrowers become more aware of their repayment options.

2. Buy up privately-held debts that are unlikely to be repaid. The federal government itself now holds at least three quarters of all student debt, thanks mostly to a 2010 law dictating that the government provide the capital for such loans going forward. The rest of the $1.7 trillion in outstanding student debt is owed to private lenders, roughly equally divided between pre-2010 loans that are federally guaranteed and loans that carry no government guarantee or subsidy.

A key component of any successful student debt repayment strategy is to recognize that the federal government is better able to help student borrowers deal with crushing debt burdens than private lenders, who need to make a profit and have less patience than government in dealing with borrowers having trouble making their payments. Thus, the key is for the government to buy and hold all risky student loans so that it can work out better terms.

For debt that the government already holds, the government has the full authority to offer borrowers the option of refinancing their existing debt into a new single note with different terms and conditions from what they are currently obligated to pay.

For debt held privately but guaranteed by the government against default, the government does have a legal obligation to pay off the loans, with interest, if the borrowers have not. This could be expensive, costing the federal government $50 billion or more over ten years. But once these loans are purchased by the government, it would have the authority to offer a range of refinancing options to get all or most of that money back.

Risky private debts with no federal guarantee can probably be bought up for a fraction of what is owed. While some holders of these loans have resisted such intervention, most would probably welcome the government coming in and buying their ‘bad’ loans at prices that reflect their underlying market value. And once these loans were purchased by the government, they, too, would be eligible for refinancing.

3. Forgive the debt of borrowers who got ripped off by the system. The biggest category of defaulting borrowers attended institutions of poor quality, mostly but not entirely those operating for profit. Making matters worse, delinquent borrowers are often hounded for repayment while the schools continue to operate. This reflects the failure of the government to exercise due diligence, which allowed these loans to be made in the first place.

To correct this failure, the debts of students who borrowed money to attend substandard programs should be fully forgiven and the poorly performing schools should be shut down. In fact, most of these loans have already been written off the federal books — just like banks write off their bad loans — so such forgiveness won’t add much to future federal spending.

Write-offs should also be available to the many thousands of borrowers who participated in the Public Service Loan Forgiveness program, which promised loan discounts to borrowers who went to work for government or non-profit organizations. But the rules were far from clear; many borrowers who thought they were following the rules made payments for years, then discovered that they were ineligible for the promised relief. This record of government mismanagement should now result in compassionate forgiveness for these borrowers.

The administration recently added another category of borrowers who should qualify for relief: those who regularly made payments for 20 years or more and still owe money. It seems a reasonable form of compassion for government to provide relief to those borrowers who have met their responsibility to repay over an extended period.

4. Allow all borrowers to refinance their remaining student debt into a single note at reasonable cost to borrowers and taxpayers. The notion that student borrowers should be able to repay their loans based on their post-graduation income has been discussed as long as there have been student loans. In the U.S., an income-contingent repayment schedule was first created in 1994 as part of the move to make the federal government the primary college loan lender. Since then, several other income-based repayment plans have been added to the mix.

The result: a great deal of confusion. To remedy this confusion, all student debtors should be allowed to refinance their loans into a single note with an affordable schedule of payments. Over the past half-century, one of the most profound and beneficial changes in the mortgage markets has been the ability of homeowners to refinance their mortgages without penalty. Applying this principle to student debt would be a huge step forward in solving the student loan crisis without costing the government more money than it is already slated to spend.

To be most effective, this new refinancing schedule should have the following characteristics:

• New loans should charge an implicit interest rate that reflects the government’s cost of money rather than the more market-based rates currently used in most student loans. This one step could reduce the cost of borrowing by 25 percent or more.
• The new consolidated loans should eliminate any interest added to principal when income-based payments fail to cover the accrued interest. This process, called negative amortization, has the effect of increasing the principal over time, even though required payments are being made. It was not part of the initial income-contingent plans, and I believe, as do many others, that adding unpaid interest to principal is unfair. For millions of borrowers, eliminating negative amortization would reduce the necessary repayments by even more than lowering the interest rates.
• Borrowers should be eligible for loan forgiveness 20 years after they borrowed so that their burdens don’t persist well into middle age and beyond. A related step would be to allow those borrowers who are helplessly underwater to declare bankruptcy, an escape option that is largely not allowed today.
• The most fundamental change, though, would be to direct all repayments into the Social Security system through payroll withholding. A withholding rate of 5 to 10 percent of a borrower’s wages would be enough to repay most student loans over a reasonable period.

Under this new arrangement, income-based repayments would be collected via regular payroll tax withholding, and those payments could be funneled into the Social Security trust fund. In this way, this plan would have help to stabilize the funding for Social Security without any impact on the deficit or government debt; the revenues from these loan repayments — as much as $200 billion a year — would simply go into a different bucket within government accounts. And student borrowers would be investing in their future by shoring up Social Security.

Collecting student loan repayments via payroll taxes would have several advantages over current arrangements in which repayments are based on filings of the borrower’s income tax returns. As a result, they often include spousal income and lag reality by a year or two. Repaying based on wages and salaries as reported on payroll taxes would erase the marriage penalty and eliminate the lag. There are even international models for such a system: Australia, New Zealand and England all have had success using withholding systems to repay student loans.

Reducing Reliance on Loans in the Future. The four steps described above will cost federal taxpayers less than $100 billion over ten years, compared with a price tag of at least $500 billion for Biden’s plans. Much of this cost would be incurred by paying off defaults on federally guaranteed private loans. But these costs could be fully paid for by reforms that will reduce the costs of loans in the future. The reforms could look like this:

• First, end the practice of charging tuition to students taking remedial courses, forcing them to borrow to pay for such courses before they have even started college-level work. Public funds, not student loans, should be used to pay the various providers of remediation based on how well they raise the basic skills of the students.
• Second, charge colleges and universities a risk-sharing fee on all new student loans, a fee which reflects the repayment history of their borrowers in the past. The lower the default rate of the institution’s borrowers, the lower the risk-sharing fee on new loans.
• Third, limit how much loans can be used for living expenses. Many students end up borrowing large sums to pay for their living expenses while in school or sometimes their family’s living expenses. Student loans are not the right way to do this. Instead, let’s redesign the Pell Grant program to help low-income students meet their living costs.
• Finally limit how much graduate students and parents can borrow. Under current law, graduate students and parents can borrow up to the amount that their program costs. This is an invitation for schools to raise their prices.

The student debt crisis is not an existential one. Rather, it is the result of public policies that have spun out of control and have failed to take fully into account the adverse cumulative effects of colleges charging too much and students borrowing too much. The solution is not to cancel the debts of people who are able to repay what they owe. The answer is to act in a compassionate way that recognizes how we got into this mess and to make the adjustments necessary to put the system back on an even keel for the longer term.