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A Student Debt Cure Worse Than the Disease

Tuesday, December 18, 2012

Taxpayers may have more reason to be concerned about the government’s response to high levels of student debt than the debt itself.

Student loans have replaced mortgages as America’s simmering financial crisis du jour. In late November, the Federal Reserve Bank of New York announced that student loan debt grew by 4.6 percent in the third quarter of 2012, swelling to $956 billion even as overall borrowing declined. Delinquency rates on those loans climbed to 11 percent, surpassing the rates for credit cards, mortgages, and auto loans, which have fallen since 2010. Quarter after quarter, the story has been the same: more people are borrowing more money for college and having more difficulty paying it back.

Observers have warned that the so-called “student loan bubble” will have dire consequences for borrowers and taxpayers. But the federal government has traditionally been sheltered from much of that risk. Student loans are not dischargeable in bankruptcy, and the feds have significant powers to get their money back — from hiring collection agencies to garnishing wages. To be sure, student loan defaults are not costless: collection costs and delayed repayments represent losses. Even after an accurate accounting of these costs, the loan program still shows up as a surplus in the federal budget.

In fact, taxpayers may have more reason to be concerned about the government’s response to high levels of student debt than the debt itself. Put simply, the student loan surplus may not last long if the recent expansion of Income-Based Repayment (IBR) takes root.

Last October, President Obama announced the “Pay-As-You-Earn” repayment option, under which eligible borrowers can cap their annual loan payment at 10 percent of their discretionary income (adjusted gross income minus 150 percent of the poverty line). To qualify, a borrower’s annual payment under the standard 10-year repayment plan must be greater than what it would be under the 10 percent cap. Once enrolled, after 20 years of payments the federal government forgives any outstanding balance, and the forgiven amount is taxed as income. The new option represents an expansion of the existing IBR policy, which capped payments at 15 percent and provided loan forgiveness after 25 years.

In their effort to provide swift help to today’s borrowers, IBR proponents have foisted open-ended costs onto future generations.

Student advocates have lauded the new option for delivering immediate help to struggling borrowers. But there are legitimate questions about how the expanded IBR will impact the federal budget going forward. The very trends that IBR was meant to counteract — the massive growth in college tuition coupled with stagnant incomes — could transform the policy into an albatross around the neck of tomorrow’s taxpayers. In their effort to provide immediate help to today’s borrowers, IBR proponents have foisted open-ended costs onto future generations.

That’s because the long-term cost of the plan depends on a quantity that is likely to grow over time: the debt-to-income ratio of graduates. If college costs and student loan debt continue their ascent while incomes lag behind, increasing numbers will qualify for the new version of IBR. And the more people that sign up, the more money the government will likely have to forgive 20 years later. 

You can already see the seeds of a costly program. In a recent report, Jason Delisle and Alex Holt of the New America Foundation document how the policy actually provides a “windfall” to middle and high-income borrowers with large amounts of graduate school debt while offering fewer benefits to borrowers with less debt and lower incomes. The latter are likely to pay off their balances — plus interest — over the 20-year period, while the former will benefit from large amounts of forgiveness. Delisle and Holt show that a law school graduate with $122,000 in debt would stand to have more than $160,000 in debt forgiven after 20 years, even with an income over $100,000 by the 11th year after law school.

Delinquency rates on student loans climbed to 11 percent, surpassing the rates for credit cards, mortgages, and auto loans, which have fallen since 2010.

It’s troubling enough that the program doesn’t seem to work as intended in today’s higher education market. But the picture gets even more concerning when we project IBR into the future. According to the New York Fed, between the third quarter of 2005 and the first quarter of 2012, the average student debt load among borrowers under 30 increased 28 percent, rising from over $16,200 to $20,800, after adjusting for inflation. Meanwhile, between 2000 and 2010, median earnings for full-time workers between the ages of 25 and 34 with a bachelor’s degree fell by nearly 11 percent after adjusting for inflation. Young workers with an advanced degree saw earnings decrease 10 percent. With more than 50 percent of recent BA recipients either jobless or underemployed as of last spring, it is unlikely that the situation has gotten much better. As these two trend lines continue to diverge, more borrowers will become eligible for the expanded IBR.

If most borrowers stood a reasonable chance of paying off their debt in the 20-year window, increases in eligibility would not necessarily translate to higher costs. The New America analysis suggests that middle-income borrowers with less than $25,000 in debt — most undergraduates — will likely repay in full over the 20 years. But the report also shows that middle- and high-income borrowers with debts above $30,000 will receive significant loan forgiveness. For some, the 10 percent payment won’t even keep up with accruing interest, resulting in negative amortization. These folks will have more debt forgiven than they took out in the first place.

To be sure, such high-debt borrowers are still in the minority. The Fed data reveal that 10 percent of borrowers have debt loads larger than $54,000; just 3 percent owe more than $100,000. But the numbers are growing. In a recent study on, Mark Kantrowitz found that the number of graduate student borrowers with debt loads of more than $100,000 grew from just over 21,000 in 2000 to 70,800 in 2008. There are almost certainly more of them five years on. 

What all of this will cost is anybody’s guess, partly because it depends on unknowns like eligibility and the take-up rate. The Department of Education forecasts that the new IBR will cost $2.1 billion over the next 10 years, based on an estimate that about 400,000 borrowers from the 2012 through 2012 cohorts will receive some amount of loan forgiveness. The Department suggests that "those receiving forgiveness have an average original balance of approximately $39,500 and receive forgiveness of approximately $41,000, as their payments tend to cover interest owed so they end up with balances forgiven close to the original debt.” But these costs are difficult to predict, particularly over the long-term. A case in point: a July analysis from Barclays argued that the actual cost of IBR would be more like $190 billion between now and 2020 — more than 90 times OMB’s projections. More importantly, whatever the actual costs for these early cohorts, it will likely be a lower bound assuming higher education costs and student debt continue to increase.

The very trends that IBR was meant to counteract could transform the policy into an albatross around the neck of tomorrow’s taxpayers.

In short, barring some sudden leveling off in college prices or significant growth in incomes, the costs of loan forgiveness will grow. These mounting costs will hamstring policymakers and hurt needy students in the future. Consider that lawmakers already face a funding gap for the Pell Grant program of just under $6 billion for 2014, even with a student loan program that shows up (rightly or wrongly) as a surplus in the federal budget. Fast-forward 20 years to when these new loan forgiveness obligations come due, turning that surplus into a large and growing cost. Where will policymakers find the money to pay for the ever-expanding Pell Grant program?

Policymakers need not abandon the idea of income-based repayment, but they should redesign the current system so that it is sustainable. Luckily, some fiscally responsible proposals have emerged. The New America analysis recommends that eligibility for the 10 percent cap be tightened to exclude high-income borrowers, and that 20-year loan forgiveness be reserved for borrowers with less than $40,000 in debt. And in a bill introduced this week, Rep. Tom Petri (R-WI) has proposed shifting all repayment to an income-contingent plan that would cap payments at 15 percent of discretionary income and do away with loan forgiveness. To protect borrowers, interest would accrue rather than compound and would stop accruing after reaching 50 percent of the initial balance.

With any luck, these ideas will start a conversation about what a sustainable policy might look like. The key question is whether advocates will recognize the need for change. Unless leaders take steps to reform the new IBR plan soon, they may find that they’ve sacrificed college access in the future for debt relief in the present.

Andrew Kelly is a research fellow in education policy at the American Enterprise Institute. 

FURTHER READING: Kelly also writes “Are Productivity Gains in Higher Education Possible?” “Study Student Aid Before You Reform It,” and “A Takeover Tale.” Kenneth Gould contributes “The High Cost of College: An Economic Explanation.” Norman J. Ornstein says “After Solving Student Loan Issue, Look at Costs.”

Image by Dianna Ingram / Bergman Group

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