Three Steps to Retire Student Debt Fairly and Responsibly

Competent Counseling for All. Relief for Borrowers Who Got Ripped Off. Optional Refinancing at reasonable cost to both borrowers and taxpayers.

Student loan payments have been on pause for the past two years to give borrowers relief from the effects of the pandemic. But when the pause ends, millions will have trouble making their payments, a situation that has launched a thousand arguments over what to do about the looming crisis.

Senators Chuck Schumer (D-NY) and Elizabeth Warren (D-MA) are leading the charge to cancel up to $50,000 of student debt. Mitt Romney (R-UT) and other conservatives are opposed, arguing that borrowers should pay off their debts, just like millions did before them.

Neither approach will solve the problem; both will just kick the student debt can down the road.

There is also a moral hazard to consider: cancellation of all student debt could create the expectation of similar treatment by future borrowers. Also, many, perhaps even most student borrowers can in fact afford to make their loan payments on time and were doing so before the pause. Thus, widespread cancellation would add hundreds of billions of dollars to the federal deficit by forgiving loans that could reasonably be expected to be repaid.

One alternative that is being pushed by some is to means test whose debt is cancelled but this could be an administrative nightmare in determining eligibility. Also, the federal government would still spend very large sums to provide relief to borrowers who can handle their repayment obligations. On the other hand, simply dismissing the need for debt relief fails to acknowledge how government policies helped create this problem in the first place.

Finally, and perhaps most importantly, neither of these more extreme approaches addresses the critical question of how we become less reliant on student loans in the future to avoid a repeat of the current crisis. Any longer-term solution must include bending back the college cost curve and other measures required to make sense of how we pay for college in this country.

How Did We Get into This Mess?

Many of the numbers on student debt are familiar. Roughly 45 million borrowers — one in seven Americans — owe more than $1.7 trillion, triple the amount just 15 years ago when adjusted for inflation. Millions of borrowers have found their lives turned upside down, forced to postpone or forgo plans to marry, buy a house, or just live a secure life because their post-college incomes are being eaten up by their student and other debts.

Not mentioned so much is that the federal government owns 90 percent of this debt. As a result, the cost of providing relief will be sharply less than if the loans were owned by banks or other private lenders. Thus, the government can and should show compassion for a problem it helped to create by cancelling billions in borrowing by students attending shoddy institutions.

Also less discussed is that a quarter or more of outstanding debt is interest, not principal. Some was predictable. With so-called unsubsidized federal loans, interest was added to principal while borrowers were still in school. But much of the additional interest was less predictable and more onerous. It was added to principal when scheduled payments weren’t enough to cover the interest that had accrued on the loan up to that point. This is a process called negative amortization, which results in borrowers owing interest on interest. It has been banned in half the states and should be eliminated in any set of student loan reforms. Meanwhile, its victims are entitled to relief.

A lot of attention has been focused on the one-third of current student debts that are unlikely to be fully repaid. But at least four-fifths of this bad paper already has been written off the federal books as part of the annual budget process, just as banks write off their bad loans. Moreover, much of this bad debt was incurred by borrowers attending low-quality institutions. The federal government should have done due diligence to prevent these students from borrowing in the first place and it should therefore forgive these loans.

For more than half a century, loans have allowed millions of borrowers to improve their lot in life by going to college. Yet many other millions have been crushed by debt when they find themselves without the good jobs and better life they were promised. The trick then is to come up with a solution that will help the people who truly need the help without subsidizing those who don’t need the help which would make a mockery of the millions who have fully met their obligations in the past.

Three Steps to a Solution

One way or another, the pause in payments will end soon. I propose the following three steps to address the looming student debt crisis.

Provide competent counseling for all borrowers. The current repayment structure is a maze of confusion and borrowers need help navigating it. The federal government should fund a network of student loan counselors in various locales and online so that every borrower would be able to consult with a qualified advisor to work out an individualized repayment plan. Counselors should also be empowered to identify viable options for people having trouble making their payments.

Forgive the debt of some borrowers. The biggest category of student loan defaulters attended 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 and profit from their misfortune. This situation represents a failure of the government to exercise due diligence, which allowed these loans to be made in the first place. The debts of students who borrowed to attend substandard programs should be fully forgiven and the poorly performing schools should be shut down.

Forgiveness should also apply to the many thousands 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. The rules were far from clear; most of these borrowers who thought they were following the rules eventually found out they were not and were forced to make payments for years, often including accrued interest. This record of government neglect should now result in forgiveness for these borrowers.

Allow all borrowers to refinance their student debt. The notion that student loan borrowers should be able to repay based on their post-graduation income has been discussed as long as there have been student loans. An income-contingent repayment schedule was created in 1994 as part of the move to make the feds the primary college loan lender. In the intervening decades, several additional plans have been added to the mix. The result: a confusing hodgepodge of repayment schedules with varied terms and conditions that are confusing and costly to the government and borrowers alike.

A key step in retiring student debt fairly, then, is to allow all those with student debt to refinance on a single, realistic schedule of payments. This solution comes out of the experience in the housing mortgage market. Over the past half century, the most profound change in housing has been the ability of homeowners to refinance their mortgages without penalty. Applying this principle to student debt would be a huge step in solving the crisis without costing the government money over what is already slated to be spent

The new refinancing schedule should set with an interest rate that more nearly reflects the government’s cost of money rather than the more market-based rates currently used in most repayments schedules. This one step will make the costs more reasonable to borrowers and taxpayers alike.

The new refinancing option should also eliminate any interest accumulated through negative amortization and make all borrowers in trouble eligible for loan forgiveness after 20 years of making payments so that their burdens don’t persist well into middle age and beyond. Some reasonable measure of income versus debt could be established to determine who qualifies for forgiveness. A related step would be to allow those borrowers for whom new refinancing is not a sufficient solution for their situation to declare bankruptcy, an escape option which is largely not allowed today.

Several categories of borrowers stand to benefit from refinancing. One is those students who for whatever reason borrowed too much relative to their future ability to repay. Another is those who have been charged large amounts of unanticipated interest after graduating, which have made their debts now unaffordable. Most of these borrowers could benefit greatly from refinancing.

There is a third group of borrowers who also could benefit from refinancing- those who are not having trouble making their payments. These borrowers, who owe at least half of the outstanding debt, should also be able to refinance all their existing student debts into the new income-based schedule. Or they could choose to continue with their amortized payments until their loan is repaid but they should not be eligible for forgiveness.

Based on international experience with income-based repayments, in the new income-based U.S. scheme, loan repayments should be made through payroll withholding rather than relying on the income tax system as the means of calculating and collecting repayments. Australia, New Zealand, and England all 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.

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Carefully planned and implemented, these three reforms can be accomplished largely within what the federal government already spends on student loans rather than asking taxpayers, most of whom did not attend college, to come up with the many billions of additional dollars that would be required to cancel large chunks of student debt.

A compassionate counseling network will allow all borrowers to have a better sense of where they stand and what their options are. Cancelling the loans of borrowers who got ripped off by the system is needed to make the system fair. And a viable refinancing option that is reasonable in cost to both borrowers and taxpayers is essential to put the system on an equitable keel.

But dealing with the current debt crisis is only one part of the solution. We must also seek to reduce the reliance on student loans in the future and to ratchet down the growth in college costs, which are at base the problem. These future steps include preventing students taking remedial courses from borrowing, limiting how much loans can be used to pay for living expenses, and requiring institutions to pay a modest risk-sharing fee on all new loans to offset the future costs of defaults. All these would help reduce how much is borrowed and would also reduce federal costs of student loans.

These proposals for future reforms will be presented in more detail in a subsequent blog. But, for now, let’s deal with the current debt crisis in a fair and responsible way that allows all student loan borrowers to get on with their life in a reasonable manner.