The One-Two Punch of Income-Based Repayment and Student Loan Refinancing
President Obama is expected to announce this afternoon an Executive Order that would extend the protections of Income-Based Repayment (or more specifically, Pay As You Earn) to student borrowers who took out loans before 2007 or stopped borrowing by 2011. In recent years, Pay As You Earn (PAYE) and other income-based repayment structures have been seen as a promising way to prevent student loan defaults; after all, you’re much less likely to default or become delinquent on a student loan if your payment is a manageable portion of your income, as opposed to a flat monthly payment that requires you to pay off the loan balance in 10 years. At a time when one in seven student loans default within the first three years of a student leaving school, and when graduates are taking on larger and larger amounts of debt, it makes sense to use everything in the toolbox to make sure that students aren’t financially ruined before they have a chance to get a start on life.
What this Executive Order amounts to is a recognition that student debt is something that hits households well beyond college age. Around a third of student debt is held by those over 40, and delinquency rates generally rise by age. My colleague Robbie Hiltonsmith has shown that college educated households with debt lose over $200,000 in lifetime wealth, primarily from retirement savings, compared to those without debt. Making payments manageable when income is iffy is one way to ensure that families have the flexibility to pay off debt over a reasonable timeframe while tending to other liquidity and savings needs.
One of the only problems with IBR, however, is that because it lowers monthly payments, it can increase the total amount a borrower pays over the life of the loan, since interest still accrues. In fact, almost every protection or non-standard repayment plan that the Federal Government offers on student loans ends up increasing the total amount a borrower must pay to offload the debt, in exchange for more manageable monthly payments. For some, this trade-off is a no-brainer—particularly if the alternative is defaulting on a loan. For others, it requires careful consideration.
This is where refinancing comes in. I’ve written before about how allowing borrowers to refinance student loans is one of the only ways to reduce the total amount of debt a borrower must repay. Senate Democrats have coalesced around a plan—supported by the president—to allow for a one-time refinancing for borrowers with interest rates above those currently set by Congress. For those with undergraduate debt, this—combined with expanded income-based repayment—could actually make a dent in their short- and long-term loan burden.
Another little-noted item in the president’s Executive Order is an announcement that loan servicer contracts are set to be renegotiated, with new incentives for servicers—which, at the end of the day, are federal contractors ostensibly serving the public good—to prevent student loan defaults. This is a welcome development for a couple reasons. First, servicers like Sallie Mae have taken some justified heat recently for using predatory tactics against military servicemembers (which resulted in a $97 million settlement), and tales of servicer incompetence or malfeasance have been around as long as the entities themselves. Second, reopening federal contracts, requiring that servicers aggressively help students avoid default could, paired with IBR, create a marketplace in which servicers are actually competing to make students aware of their protections and options. Under the previous system of bank-based student lending, servicers and guarantee agencies did have some incentives to keep defaults down – essentially the higher the default rate, the less a guarantee agency (and thus, a lender) could recoup in defaulted student loans. There is virtually no reason to return to a system in which the government is doling out money to middlemen to guarantee loans, but some level of incentive among servicers in the Direct Loan program to reduce default is a welcome sight.
Despite what the media narrative may be, there’s only so much the president can do by himself with regard to student loan debt. It’s the job of Congress, not the president, to add real incentives and funding into the system to lower the cost of college and reduce the need to borrow in the first place. Only Congress can give students the ability to refinance loans, allocate more funds to need-based aid, or structurally change our debt-for-diploma system. The president doesn’t have a magic wand at his disposal, but making sure that more borrowers are covered under existing protections and repayment plans is a pretty essential place to start.
 Pay As You Earn and other IBR options do have forgiveness provisions attached. If after 20 years you still have a loan balance remaining, and haven’t skipped payments under PAYE, the remaining balance is forgiven. So in this sense, PAYE could reduce the total amount a borrower pays on a loan. But his or her income would have to be low enough for 20 years, and loan balance high enough, to receive forgiveness. The vast majority of undergraduate borrowers under PAYE are not expected to receive forgiveness, and many have noted that the forgiveness provisions are much more likely to benefit those with high levels of graduate school debt rather than undergrads.
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