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Student Loan Repayment Plans Fail Small Borrowers

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On the campaign trail, candidate Trump proposed doubling down on income-driven repayment as a solution for student borrowers struggling to repay their loans. The latest data release on the Department of Education’s student loan portfolio shows that Trump was right on the need for a solution but wrong about its substance.

At the start of 2017, the balance of direct student loans in default stood at $72 billion—a figure which has more than doubled in just three years. But defaulting borrowers tend to have low balances—just $17,000 on average, according to the most recent figures. Meanwhile, the average borrower actively repaying his loans has an average balance of over $31,000.

Trump’s proposal to help distressed borrowers would cap loan payments at 12.5% of discretionary income and forgive any remaining balances after 15 years. This idea mirrors the income-driven repayment (IDR) plans developed under the Obama administration, which allow borrowers to pay a certain percentage of their discretionary income (usually 10%) and receive forgiveness after 20 or 25 years. These plans have grown substantially more popular in recent years and now enroll roughly six million borrowers.

However, borrowers are usually not allowed to enroll in IDR plans if their income-based payments exceed what they would pay under the ten-year standard plan. Even if it were allowed, it would be irrational for a struggling borrower to enroll in IDR if it would increase their payments. Under the standard plan, payments are lower when a borrower’s starting debt balance is lower. Therefore, a borrower with a small amount of debt usually cannot take advantage of IDR programs.

Preston Cooper/Forbes

Consider the example of a single person with $5,000 in debt. Depending on his interest rate, his annual payments will be between $609 and $705 under the standard plan. Under the income-based repayment plan, his annual payments will go down only if his income is below approximately $25,000. Lower-middle-income borrowers with small balances, therefore, will usually not benefit from IDR.

Now consider a single person with $50,000 in debt. Under the standard plan, his payments range between $6,091 and $7,053. Unlike the low-balance borrower, these payments are high enough to make income-based repayment advantageous for income levels up to $79,000 or even $88,000, depending on his interest rate.

The slice of the income distribution eligible for IDR thus increases with the borrower’s balance. Data from the Department of Education reveal this. Recall that the average individual repaying their loans owes about $31,000. But the subset of people in income-driven repayment owe far more: between $41,000 and $57,000 on average, depending on the plan. Meanwhile, the average borrower on the standard ten-year plan owes just $18,000.

Preston Cooper/Forbes

Income-driven repayment is expensive for taxpayers, since it allows borrowers to defer payments and even get part of their balances forgiven. But this largesse is going to exactly the wrong people: student borrowers with lower balances are the ones who default on their loans at the highest rates, and are therefore in most need of assistance. These borrowers are less likely to have completed their degrees, and thus are stuck with debt but no credential—and none of the employment opportunities commensurate with a college education. Unless they have very low incomes, these low-balance borrowers cannot benefit from the federal government’s generous IDR plans.

Congress could fix this by allowing the Department of Education to vary the share of income a borrower pays under IDR with his balance. Currently, almost all new IDR borrowers pay the same 10% of their discretionary income, regardless of whether their balance is $10,000 or $100,000. It shouldn’t be a radical idea to keep loan payments at least somewhat linked to what the borrower actually took out.

Reducing IDR payment rates for low-balance borrowers would mean that a greater swath of these borrowers would be able to take advantage of the program, since it would be more likely that the fixed standard plan payment would exceed the new, lower, IDR payment. And increasing IDR payments for high-balance borrowers would help taxpayers by making it less likely that these individuals would receive loan forgiveness at the end of their repayment periods. It would also discourage students from borrowing more than they need, since they would no longer have the guarantee of capping their payments at 10% of discretionary income.

Tying student loan payments to income is an idea that goes back to Milton Friedman. However, the current income-driven repayment system, which insists on a one-size-fits-all rate for all borrowers, is a perversion of the idea’s original intent. President Trump and Congress have an opportunity to get it right. They should act quickly, though, as the rate of student loan defaults is creeping up all the time.