Details of the Plan for Fair Loan Payments

How the Plan for Fair Loan Payments Works

Under the Plan for Fair Loan Payments, when a borrower earns less than 150 percent of the poverty level for their family size they would be required to make no more than nominal payments on their federal student loans. Above that level of income, a borrowers required payments could not exceed 15 percent of each additional dollar earned. With this approach, that majority of borrower’s would see their loan payments capped at less than 10 percent of their total income.

The Department of Education would cover any unpaid interest on subsidized Stafford or Perkins loans resulting from reduced payments. Interest would continue to accrue on all other federal student loans.

The Need for a Plan for Fair Loan Payments

Coverage gaps. To illustrate the deficiencies in the current system, refer to the graph below showing the level of payments that are on the borderline of manageable. The chart is based on the recent research of two economists, Sandy Baum and Saul Schwartz.[3] But it will make sense to non-economists, too.

At the lowest income levels, a borrower is not in a position to make anything more than a nominal payment, represented by the horizontal portion of the red “Manageable Payment” line. That line turns upward as the borrower’s income rises, because she can begin to set aside a portion [4] for payments on student loans.

Standard payments on student loans are unrelated to income, and are generally set so that the borrower can make the same monthly payment and finish repaying the loan in a certain time period: the standard is 10 years. The monthly payment level is represented on the graph below by the dotted line. The shaded area represents payments, or portions of payments, that it would be unreasonable to expect borrowers to be able to afford given their income.

The goal of the repayment system in a government loan program is to ensure that borrowers make payments whenever it is reasonable to expect that they can. The vast majority of borrowers meet this criterion, most of the time. But when borrowers face genuine economic hardship (the shaded area at the left side of the above graph), it is appropriate for a loan program to ensure that payment requirements remain reasonable. To what extent does the current federal program do this? The shaded area represents the situations for which the current “economic hardship” deferment provides relief. They are shown in blue in the graph below. The area is oddly shaped because the deferment language is oddly written. While an important subset of struggling borrowers is eligible for economic hardship relief, many who are in similar need do not make the cut.

Not shown in the graph is the fact that the current hardship protection is the least helpful to borrowers who face the greatest demand for their limited resources: those with children. A single borrower with an income of $30,000 is certainly in a much better position to make payments on her loan than a mother of two children with the same income. Yet the current hardship protection treats the two situations exactly the same way. In addition to filling in the gaps in coverage, revised borrower protections should take family size into consideration in defining reasonable payment levels.

Payment Disincentives. Some of the current repayment policies, because of the way they are designed, can actually have the opposite effect from what we would want out of good public policy. This is particularly true of the all-or-nothing interest relief under current economic hardship provisions. For example, a pre-school teacher with $25,000 in student loans, making $17,500, would normally be happy to be offered a 10 percent raise. However, with that raise he would lose eligibility for interest relief and be slightly worse off. The same is true for a medical resident earning $39,000 with student loan debt of $75,000.[5]

How a Pre-School Teacher Could Be Worse Off With a Raise
Student loans: $25,000
	Before 10% raise	After 10% raise
Annual Income	$17,500	$19,250
Student Loan Interest Relief	$1,785	not eligible
Net Income	$19,285	$19,250

How a Medical Resident Could Be Worse Off With a Raise
Student loans: $75,000
	Before 10% raise	After 10% raise
Annual Income	$39,000	$42,900
Student Loan Interest Relief	$5,335	not eligible
Net Income	$44,335	$42,900

The current provisions also have different and in some cases more generous eligibility criteria for those who are working part time than for those who are working full time. The way they are designed, there are situations when it would be in a low-income borrower’s financial interest to work less.

The improved repayment protections that we are recommending would provide appropriate relief to borrowers, but would improve upon the current system by ensuring that borrowers have a financial incentive to earn more if they can.

Confusion and inequity. The above description of economic hardship presumes that the borrower is actually able to figure out whether and under what circumstances she would qualify for relief. As it turns out, that is not a reasonable assumption. The design of the benefit is bizarre and illogical, and the borrower is unlikely to be made aware of it in the first place. The route most likely to be offered to a struggling borrower when she contacts her lender is “forbearance,” which allows her to put off payments without going into default. This cessation of payments may be useful, but it is also costly, with interest charges piling quickly onto an already unmanageable loan. We are told that in many cases borrowers who might be able to take advantage of interest relief through the economic hardship deferment are not informed of the option. It is understandable: forbearance is an easy process for the lender and the borrower, while economic hardship—which is substantially better ultimately for qualifying borrowers—involves no less than seven pages of forms and worksheets.

Another option that borrowers have—if they are told about it—is income-contingent repayment (ICR)[6]. For borrowers who are going to be struggling for many years, it might be best to be in ICR, to be able to make use of forgiveness after 25 years. But most do not know whether and when their economic situation will improve. The down side of ICR is that interest charges continue to build up, even for those borrowers who would have gotten interest relief under economic hardship. So if the outlook is less grim, it might be better to take an economic hardship deferment. This is not easy to figure out. For many, it’s impossible.

The goal of these suggested improvements is to end the guessing game for borrowers who are struggling, without foreclosing their options. Whether they have a FFEL loan or a Direct loan, borrowers facing heavy repayment burdens could take advantage of interest relief under economic hardship, and would also maintain their eligibility for ultimate forgiveness, if they end up in the unfortunate circumstance of a long-term, high-debt, low-income situation.

Fortunately, Congress can go a long way toward addressing these problems by taking up these issues of coverage, consistency, clarity, and equity.

1. Milton Friedman, “The Role of Government in Education,” in Robert A. Solo, ed., Economics and the Public Interest, Rutgers University Press, 1955.

2. U.S. Census Bureau, Current Population Survey, 2005 Supplement. Computations by the Project on Student Debt.

3. Sandy Baum and Saul Schwartz, How Much Debt Is Too Much? Defining Benchmarks for Manageable Student Debt, The College Board and the Project on Student Debt, 2006.

4. How much, and at what income level, are discussed later.

5. These examples assume the current 7.14% interest rate on variable-rate loans made prior to July 1, 2006, and they assume the loans are all subsidized (which means that the government pays all of the interest during economic hardship status, for up to three years).

6. Under the current system, ICR is only available in the Direct Loan Program, which serves about 25 percent of students. Borrowers currently in the guarantee program known as the FFEL (Federal Family Education Loan) Program must to consolidate their loans into the Direct Loan Program in order to access ICR.