September 27, 2022
Student loans are the second largest type of consumer debt in the nation with 43 million borrowers ahead of $1.6 trillion, second only to mortgages.
After COVID-19 disrupted the US economy in March 2020, federal student loan payments and default collections were suspended and interest waived. These pandemic accommodations have been extended seven times and are now due to end on December 31, 2022.
A report by credit reporting agency Equifax predicts that once federally guaranteed loan repayments resume, they will cover nearly $900 billion in student bonds for an average monthly payment of $244. Although most borrowers are unlikely to have difficulty making their payments initially, delinquency rates on student loans in repayment hovered around 30% before the pandemic.
The Biden administration recently announced new student loan relief, including the cancellation of at least $10,000 in federal loans for borrowers earning less than $125,000 ($250,000 for married couples) and more for Pell Scholarship recipients (undergraduate students with extraordinary needs). The White House estimates the plan will cost at least $240 billion, raising equity and inflation concerns. Some details are unclear; the final rule and implementation plan will be released after a public comment period.
Participation in the income-tested reimbursement scheme increases
Student loan balances rose, a trend largely reflecting rising college tuition fees. The average student loan balance increased by nearly $7,000 from the fourth quarter of 2016 to more than $36,000 in the fourth quarter of 2021, according to an analysis of the most recent reliable data from the New York Fed Consumer Credit Panel/Equifax. , an anonymous 5% nationally representative sample. of American consumers with a credit history.
The share of borrowers with more than $50,000 in student debt rose from 16.6% to 21.4% over this period, even though most borrowers’ obligations were less than $20,000 (Chart 1).
To afford larger loans, many borrowers have opted out of the standard 10-year repayment plan and opted for extended, graduated, or income-driven (IDR) repayment plans that offer lower upfront monthly payments and a loan forgiveness after 20 or 25 years of payments.
The share of federal student borrowers in IDR plans has increased from 26% in 2016 (representing 44% of loan balances) to 34% in 2021 (representing 55% of loan balances).
The plan recently announced by the Biden administration includes new rules for IDR repayment plans that aim to further reduce the burden on borrowers and reduce defaults. The plan simply forgives some student loan debt for most borrowers; this is in addition to IDRs which already include loan cancellation provisions. In sum, the Biden plan makes future repayments far less costly for borrowers and changes payment dynamics for many.
Longer payments although little reimbursed
The standard 10-year repayment plan requires 120 fixed monthly installments to cover principal and interest. In contrast, the payment schedule for existing IDRs differs depending on the plan, loan amount, and borrower income.
Under the most popular existing pre-Biden plan — Revised Pay As You Earn (REPAYE) — borrowers pay up to 10% of Discretionary Income — defined as the amount of income above 150% of the federal poverty level. (The 2022 poverty line is $13,590 for individuals, $23,030 for an individual with two children, and $27,750 for two people with two children.)
Payment amounts are recalculated each year based on changes in the borrower’s income and family size. Loans are canceled after payments have been made for 20 years (undergraduate studies) or 25 years (graduate or professional studies). High-income, low-debt borrowers repay their loans faster and are therefore less likely to get loan forgiveness (Chart 2).
The new plan provides debt forgiveness of $10,000 and requires lower monthly payments for participants. Meanwhile, borrowers pay up to just 5% of discretionary income — now defined as income above 225% of the federal poverty level — and unpaid interest is no longer added to the loan balance.
The balance for those who borrow less than $12,000 is canceled after payments for 10 years, compared to the previous 20 years. Repayment is often longer because for most borrowers, the cumulative payments fall below the loan amount or even the interest due before reaching forgiveness.
Costs differ depending on repayment scenario under existing plan
Due to inflation and the resulting poverty line adjustment, it is useful to look at the actual costs of student loans in today’s dollars, i.e. net present value . The left panel of Figure 3 illustrates the simulated net present repayment values for borrowers; two income levels and two loan amounts are shown.
For those who borrow $30,000 and earn $40,000 in initial adjusted gross income (the total of all income less tax deductions), REPAYE costs $5,194 more than the standard 10-year plan due to interest payments. higher interest over a longer period.
But for REPAYE participants who borrow $50,000, the cost of the loan only increases by $906 (compared to those who borrow $30,000), much less than under the standard fixed amount repayment plan. .
The net present value would not exceed $40,591 regardless of the amount of debt borrowed for those initially earning $40,000 in adjusted gross income, as the program requires 240 payments before the remaining balance is forgiven. The larger the loan, the longer it is forgiven.
For REPAYE participants with an initial adjusted gross income of $60,000, paying off a $30,000 loan only slightly lowers the cost of the loan compared to the standard plan. With a $50,000 loan, however, making income-contingent payments would cost significantly more than the standard plan because repayment takes longer, but not long enough for the forgiveness provisions to apply.
REPAYE is therefore a preferable plan for low-income borrowers with higher debt. Even under the old plan, borrowers with discretionary income below 150% of the poverty line can waive payments and have all loans forgiven. Due to the unlimited forgiveness at the end of the payment period, the program risks encouraging borrowers to take on excessive debt, seek lower-paying jobs, or become relatively less engaged in the labor force – a matter of fact. moral hazard.
Among borrowers on IDR plans, 31% won’t repay any debt because their income-based payment is lower than interest, according to a study by the JPMorgan Chase Institute. Ironically, the study also noted that low-income borrowers who are eligible and could benefit the most from IDRs are less likely to enroll and, therefore, spend a much larger share of their net income on loan repayments. students.
Costs largely dependent on income under new scheme
Under the Biden plan, with a federal loan forgiveness of $10,000 and other provisions in income-contingent repayment, participants in the standard plan receive the same amount of principal reduction (net present value of 10,000 $) regardless of loan size if they borrow $10,000 or more. A borrower with less than $10,000 in debt will get less than $10,000 in relief. And those who have already repaid their loans get nothing.
There are also equity concerns among borrowers participating in the new IDR plans. If all borrowers can also participate in the new IDR plan (as shown in the right panel of Chart 3), the repayment net present values are the same ($10,331) for borrowers earning $40,000 initial AGI regardless the loan amount because they make the same payments for 20 years based on income.
For higher income or less indebted borrowers, the relief could reduce the duration of payment and the total interest paid. For borrowers earning $60,000 upfront AGI, borrowing $30,000, and receiving $10,000 forgiveness, their loan is paid off in 201 months. The net present value of the cost of the loan is $25,461; their maximum cost remains $30,433 if they borrow more than $23,000 because payments are determined by income, not the amount owed.
The new plan is expected to boost participation in IDRs that reduce payment burden. Imposing a cap on a borrower’s income to qualify for forgiveness or increasing the amount of forgiveness for low-income borrowers could mitigate the regressive nature of blanket loan forgiveness.
However, if future loan payment is largely determined by income and not by the amount borrowed, the new plan may exacerbate the moral hazard problem where the rational borrower suppresses his income while increasing his debt in order to maximize the amount of the remitted loan. This incentive problem and the inefficient allocation of public resources are of concern.
In sum, costs and distributional effects must be carefully assessed when making changes to the student loan program.
About the Author
Di is a senior research economist at the Federal Reserve Bank of Dallas.
The opinions expressed are those of the authors and should not be attributed to the Federal Reserve Bank of Dallas or the Federal Reserve System.