The Great Student Loan Giveaway

Last week, the New America Foundation published our report on the Obama administration’s pending changes to a federal student loan repayment plan, known as Income-Based Repayment (IBR). The Administration says the changes, enacted through regulation and scheduled to take effect later this year, are aimed at helping lower- and middle-income families struggling to repay their student loans. But our analysis, detailed in Safety Net or Windfall? Examining Changes to Income-Based Repayment for Federal Student Loans, finds that the changes will do a lot more than that.

Specifically, borrowers who attend graduate and professional schools and borrow to pay for their education will be able to make small monthly payments on their loans and then qualify for loan forgiveness after 20 years even if they earn a high income for most of their repayment terms. Relatedly, the plan threatens to eliminate any pricing discipline the market imposes on graduate and professional schools as the pending changes to IBR will indemnify their students from the financial risk inherent in borrowing massive sums of money.

Washington policymakers on both sides of the aisle appear to have been caught flat-footed by the findings in our report. It seems as if no one realized that the pending changes to IBR would provide windfall benefits to high-income graduates.

Fortunately, the changes proposed by the Obama administration aren’t yet final and the U.S. Department of Education still has time to reevaluate the pending changes. Therefore, we detail a number of changes that the Administration can make to the plan that will target its benefits only to lower- and middle-income borrowers.

What is “Income-Based Repayment” And Why is it About to Change?

Congress and President Bush created the Income-Based Repayment program for federal student loans in 2007 (we refer this initial program as “Old IBR”), under which a borrower may elect to have his student loan payments limited to 15 percent of his adjusted gross income (AGI), after deducting 150 percent of the federal poverty guidelines for his family size. If after 25 years of payments he still has an outstanding loan balance, the federal government forgives it. In his 2010 State of the Union Address, President Obama argued that lawmakers should reduce payments under IBR to 10 percent of AGI and provide loan forgiveness after 20 years of payments. Congress obliged, but limited the more generous program to students who take out their first loans on July 1, 2014, or later. But, in 2011, the Obama administration announced that it would make this plan available as soon as 2012 through an executive action. (We refer to these pending changes as the “New IBR.”)

High Income Borrowers with Graduate Degrees Stand to Gain the Most

While reducing the payment rate under IBR from 15 percent to income to 10 percent and providing loan forgiveness 5 years earlier might not sound like a big change in policy, a closer analysis reveals that it provides a significant increase in benefits—but only for borrowers with higher incomes. After developing a calculator that reflects all of IBR’s labyrinthine rules and can incorporate a borrower’s full 25-year repayment term, we were able to run hundreds of different borrower profiles to examine the effects of both the New and Old IBR. The findings from those efforts are the following:

• Lower-income borrowers will see minimal new benefits from the pending changes to IBR. These borrowers have too little income above IBR’s “cost-of-living” exemption (150 percent of the federal poverty guidelines based on household size), such that reducing their monthly payments from 15 to 10 percent amounts to a reduction of $5 to $20 in their monthly payments. The shorter loan-forgiveness time period only truncates a repayment schedule under which borrowers were making no or very small monthly payments to begin with.
• Borrowers with middle incomes will receive some increase in benefits under New IBR compared with Old IBR, but only if they borrow the maximum in federal student loans ($31,000 for dependent undergraduates). Even so, annual and aggregate loan limits minimize the benefits that the changes to IBR will provide to borrowers who have undergraduate loans. Middle-income borrowers with less debt will actually pay more and for longer due to the pending changes because they will incur greater interest costs. 
• Middle- and high-income borrowers who attend graduate and professional school will see significant new benefits from New IBR. The federal student loan program allows graduate students to borrow unlimited amounts to pay for the cost of their education. Due to the lower payment calculation and shortened loan-forgiveness period in New IBR, these borrowers will bear only a fraction of the incremental cost of borrowing an additional dollar once they reach $40,000 in debt, and incur no incremental cost in borrowing an additional dollar after they reach $60,000 even if they earn a high income over most of their repayment terms. Borrowers with such debt levels are very likely to have substantial amounts forgiven under the pending changes to IBR, even if they earn six-figure incomes.

How to Address IBR’s Windfall Benefits

Our paper outlines ways in which policymakers should amend the pending changes to IBR to limit the benefits it provides to borrowers with both high-debt loads and high incomes, and yet preserve the benefits that the pending changes will provide to lower-income borrowers. Because the regulations that will implement the Obama administration’s changes to IBR have yet to take effect, the Administration still has time to fix the problems that our paper exposes. Moreover, the statutory version of the changes enacted in 2010 won’t take effect until 2014, so lawmakers also have time to address New IBR’s flaws before borrowers enroll in that program. To address IBR flaw’s, policymakers should adopt the following changes:

• Maintain the lower payment calculation (10 percent of income) only for borrowers with incomes at or below 300 percent of the federal poverty guidelines. Borrowers with incomes above that level should pay 15 percent of their incomes.
• Provide loan forgiveness after 20 years of payments, but only for borrowers whose loan balances when they entered repayment did not exceed $40,000. Borrowers with higher initial balances would still qualify for loan forgiveness after 25 years of repayment.
• Eliminate the maximum payment cap that allows higher-income borrowers to make payments that are no longer based on their incomes. The cap increases the chances that a borrower earning a very high income would qualify for loan forgiveness.
• IBR payments for a borrower who is married but files a separate income tax return should be based on the household’s combined income, unless both earners are repaying student loans through IBR, in which case each borrower would pay based on half of the total household income. The program currently allows a married borrower who is in a high-income household, but individually earns a low income can still qualify for IBR (including loan forgiveness) by filing a separate income tax return.

To be clear, the Income Based Repayment plan for federal student loans is based on sound principles. It provides borrowers who otherwise might default with a reasonable safety net. But sound principles do not alone make good policies. Policymakers must still get the details right. Had they done that when they opted to make IBR more generous, they would not have opened huge loopholes that, left unclosed, will divert taxpayer dollars to wealthy graduates while simultaneously reducing incentives for overly expensive colleges to restrain tuition growth. Policymakers can, however, still get the details right by adopting the changes we recommend in our New America Foundation paper, which restore IBR to a fair, responsible, and targeted federal program.

Jason Delisle is the Director of the Federal Education Budget Project at the New America Foundation. Alex Holt is a Program Associate at the New America Foundation.