Getting Student Debt Under Control Once and For All Borrowers

Would cancelling all student debts reduce the excessive reliance on such loans to pay for college? No, it wouldn’t. There are better ways to reduce onerous debt burdens.

The $1.7 trillion in outstanding student debt has become a political lightning rod in this country. Millions of borrowers are struggling to make their payments and many have simply given up. In response, some on the left insist that large scale debt cancellation is the only answer.

But while the problem is very real, canceling everybody’s student debt is a bad idea. It would be unfair to the many millions of borrowers who have fully repaid their loans in the past or who can be expected to pay them off in the future. Moreover, cancelling a lot of loans now will make matters worse if it encourages students in the future to borrow more freely in the belief that their debts will also be forgiven. Economists call this a moral hazard.

Still, criticisms of large-scale loan cancellation don’t make the problem go away. Three very valid concerns about current and future student debt levels must be addressed. They are: providing repayment relief during the pandemic; making sure repayment is manageable for all those who currently have debts; and sharply reducing the need to borrow in the future.

We can meet these daunting challenges without large scale cancellations. And, taken together, the changes suggested below need not cost the federal government more than what it currently spends for loan subsidies, defaults and administration.

The Nature and Scope of the Problem

More than 40 million people now owe student loan debt. Four-fifths of these borrowers took out loans financed with federal capital. The rest started out using private capital, either guaranteed by the federal government or unguaranteed. These figures do not include all of what has been refinanced through broad private loan consolidation companies such as SoFi.

Based on historical experience, some two-thirds of existing student debt will be repaid, much of it on an amortized basis unrelated to post-graduation earnings of the borrower. But that means at least one-third will not be fully repaid, and much of this bad paper has already been written off the federal books. Also, much of this bad debt was incurred by borrowers who went to low-quality institutions that the federal government should have prevented from making such loans in the first place.

A significant share of the outstanding debt also is the result of interest being added to the initial amount borrowed. Some of that accrual was predictable — it occurred with so-called unsubsidized federal loans where interest accrues is added to principal while borrowers are in school. But a lot of that interest accrual is less predictable — it occurs when borrowers’ payments weren’t enough to cover even their loan’s interest. This process, called negative amortization, has been banned in half the states and should be eliminated in any reasonable set of student loan reforms.

To deal with these realities, here is a menu for what should be done in the immediate, medium and longer term to make student debt manageable for all borrowers.

I. Deferring Payments of Principal and Interest During the Pandemic

Millions of student borrowers are having trouble making their payments during the pandemic. The most direct way to help them is to extend the provisions already enacted that allow borrowers to defer their payments until the pandemic crisis has passed. It looks like the Biden administration has rightly decided to do that.

A key question, though, is how much will it cost the federal government to exhibit this form of compassion. Least costly to the government would be to allow borrowers to add their unpaid interest to principal when repayments are resumed. More costly, but more beneficial to borrowers, would be for the government to forgo interest payments for borrowers who demonstrate difficulty in making their payments.

It’s worth noting that the cost of forgoing interest payments on federally-financed student loans is significantly less than on debt held by bankers or other private lenders. This is because the government’s own cost of money is much lower than what it would have to pay private lenders.

II. A Triage Approach for Paying Off Outstanding Student Debt

Clearly, many current student debtors need help. A good place to start would be for the federal government to create a network of student loan counselors in various locales and online so that every borrower would be able to consult with a qualified advisor, who could then triage borrowers into one of three borrower categories and produce an individualized repayment plan.

1. Borrowers who attended poor-quality schools. The biggest category of student loan defaulters attend schools of poor quality, mostly but not entirely for-profit schools offering short-term training. Making matters worse, these delinquent borrowers are often hounded for repayment while many of the poorly performing schools continue to operate. This situation represents a failure of the government to exercise due diligence, which allowed these loans to be made in the first place. To redress this wrong, the debt burdens of students who borrowed in order to attend substandard programs should be fully forgiven and the poorly performing schools should be shuttered.

Forgiveness should also apply to the many thousands of borrowers who participated in the Public Service Loan Forgiveness program, which promised loan write-offs to borrowers who went to work for the government or a non-profit organization. Most of these borrowers thought they were following the rules, then found out they weren’t and were forced to make payments for years, often including accrued interest. These years of government neglect should now result in total forgiveness for these borrowers.

2. Students who attended legitimate programs but whose repayment obligations exceed a manageable share of their income. Too many students unwittingly borrowed too much relative to their ability to repay. Or they have been charged large amounts of unanticipated interest after graduating, which made their debts unaffordable.

A compassionate policy would allow all these current debtors to consolidate and refinance their student debts into a single package that allows them to repay based on their income. Income-contingent repayment programs that do exist have become a confusing hodgepodge of schedules that often are costly to the government and borrowers alike. We need a new schedule that is reasonable in cost to both borrowers and taxpayers, that excludes interest accumulated through negative amortization and that makes borrowers eligible for loan forgiveness in 20 years so that their burdens do not persist well into middle age and beyond.

Also, learning from international experience, loan payments should be made through payroll withholding rather than relying on the income tax as the means of calculating and collecting repayments. Australia, New Zealand, and England have had much better experience with income-based repayments tied to withholding, which provides a more current and accurate measure of ability to repay than an income-tax based system.

3. Borrowers who can afford their student loan repayment obligations. There is a third group of borrowers that is often overlooked — those who are not having trouble making their payments. They owe at least half of the outstanding debt. These borrowers, too, should also be able to refinance all their existing student loans into the new income-based repayment scheme or choose to continue with their amortized payments until their loan is repaid. Unlike borrowers who are having trouble affording their payments, however, these borrowers should not have the option of debt forgiveness after 20 years. Some reasonable measure of income versus debt could be established to determine who qualifies and who doesn’t.

It is important to realize that much of the loss that will be incurred on the $1.7 trillion in debt was built into estimates of the long- term federal budgetary costs when the loans were initially made. In other words, a certain level of default was anticipated to begin with. Thus, the cost of cancelling these bad debts would substantially be less than the current value of the debt itself. Moreover, whatever additional costs are incurred in loan cancellation and forgiveness, as described above, can be offset by cost savings from reducing excessive reliance on future borrowing, as described below.

III. Reducing Excessive Reliance on Borrowing in the Future

As crucial as it is to deal with the consequences of current debt, reducing the longer-term reliance on loans is at least as important. A number of steps could be taken. These include the following.

Pay for remedial courses only if students succeed. In the existing system, many students who need to take remedial, below-college-level courses must borrow to pay regular college tuition. This is wrong. There should be no tuition charged nor loans borrowed for these courses. Instead, the federal, state, and local governments should pay the providers of remedial courses based on how well they raise the basic skills of students. The cost savings in reduced interest subsidies and defaulted loans would more than pay for this shift to a performance-based system.

Restrict the amount of loans that can be used to pay for living expenses. Too much of student loans under existing policies are used to pay for the living expenses of students and, in some cases, of the students’ families. In fact, many students in community colleges and some in public four-year institutions borrow more for living expenses than for tuition. This pattern contradicts the principle that loans should enable people to invest in themselves by helping them pay tuition and fees. The U.S. approach is also inconsistent with the many international student loan programs that allow borrowing only for tuition and fees and not for living expenses.

A shift to a student loan model focused on meeting tuition and fees would be greatly helped along by making Pell Grants into a program to help low-income students pay living expenses. Then states and institutions themselves would become responsible for making sure their students could afford tuition.

Introduce a Risk-Sharing Fee. One reason student loans and defaults have grown so much over time is that the institutions themselves have no skin in the game: when a borrower defaults, it costs the institution they attended nothing. To reduce future borrowing and help pay the costs of defaults, all institutions participating in the federal student loan programs should have to pay a modest fee at loan origination that is inversely based on the default experience of that school’s borrowers- the higher the non-repayment rate, the higher the fee. This fee would not only help pay for future defaults but would reduce existing incentive for institutions to encourage maximum borrowing by their students.

Require Institutions to Offer Discounts to Their Student Borrowers. Ultimately any successful reform of the student loan system requires reducing the tuition and other charges that students must pay. Otherwise, student loans will simply continue to be the financial underpinning that allows institutions to increase tuition at rates well in excess of inflation.

One way to unwind the tuition spiral in the future is to not allow institutions to let their students borrow the full difference between their sticker price and what the student can afford. Schools should be required to offer discounts, thus reducing the amount that must be borrowed.

The steps described here, taken together, could substantially reduce the federal costs of student loans in the future and help to pay for steps to reduce the adverse effects of outstanding debt. They could also help to pay for expansion and reform of other student aid efforts.

If more savings are needed, the longstanding practice of the federal government paying the interest for needy undergraduates while in school could be eliminated. This would move student loan subsidies from the front end to the back end of the borrowing process, which is where many of us believe they most rightly belong.

The proposals laid out here are a far better way than large-scale debt cancellation to address the very real problem of excessive reliance on student loans, both now and in the future. Carefully planned and implemented, these reforms can be accomplished within what the federal government already spends on student loans rather than requiring many billions of additional dollars that would be required to cancel large chunks of student debt.