Among the urgent situations facing President-elect Joe Biden shortly after he was sworn in on January 20 is the expiration of CARES law compliance with student loans (principal and interest) 11 days later and the tidal wave of new payment standards that are likely to follow.
Biden has repeatedly committed to free up $ 10,000 in higher education debt per. borrower. At the far end of the progressive political spectrum, however, amounts of $ 50,000 and more are banded.
In other words, unqualified amnesty.
But the notion of forgiveness of loans – whether in full or in part – is a political purpose. An ineffective remedy that does not give sufficient weight to several fundamentally important considerations.
To begin with, should all student borrowers benefit from this greatness?
According to the Federal Reserve Bank of New York’s quarterly report on household debt and credit was more than 20 per cent of all education-related loans currently being repaid – amounting to approx. half of all student loans – 90 days or more due at the end of the calendar quarter immediately before the passage of the CARES Act in March last year.
Given that crime rates are typically measured 30 or more days due, it is reasonable to assume that the true the payment rate is much higher. Add to that the loans that were temporarily put into excusability before CARES, plus those that have been restructured under the countless U.S. income-based repayment plans for the U.S. Department of Education, and it is not a stretch to estimate that 40 percent or more of all loans there currently in repayment is actually troubled debt.
But that leaves the 50 or 60 percent of student borrowers who seem to have the funds to continue making their monthly payment in full and on time. This extension of forgiveness to these debtors is unjustified.
And then there is the question of equity: if everyone with existing debt was granted amnesty today, should not all those who have repaid their education-related debt in the past have to get a refund?
Second, what effect would the amnesty have on taxpayers?
For every dollar that the Department of Education lends to higher education students, it borrows an equal amount to fund this activity. At its Sept. 30, 2020, end of fiscal year, the fund reported $ 1.1 trillion in Federal Direct loan receivables (the amount owed by its borrowers) and $ 1.16 trillion in equivalent debt (the amount the U.S. Treasury borrowed on on its behalf).
Theoretically, one should offset the other when debtors repay their loans, which means that taxpayers are then kept harmless. But loan forgiveness would change that calculation with the resulting shortfall added to the growing federal deficit.
Third, what about the lingering consequences?
Consider that the dollar value of debt that is fully or partially released is treated as ordinary income under the tax code. As such, student borrowers whose obligations are forgiven would still have an IRS bill to pay.
What’s more, they would also assume the long-term credit-related consequences of their forgiven loans, as FICO scoring algorithms would take them into account, and credit bureau reports would also show the record of payment defaults that led up to that point.
Last and perhaps most important is the damage that would be done to the basic principal of lending.
Credit is basically a function of trust: I will lend you $ 100 now because I trust you will pay me back later. This trust is challenged if you pay me back less than I lent you – and violated if you do not pay me back at all.
Certainly, loan losses are a reality for lenders. It is a metric that lending institutions closely monitor and routinely model so that they can integrate the dollar value of the default probability into their loan pricing matrices.
In other words, they strive to quantify the net dollar value of confidence. As such, forgiveness of loans on a scale currently under consideration would raise this calculation, resulting in higher interest rates on future loans, if not termination of the loan product in question.
A better way forward
The sharp mistake here is that the amnesty empties the bucket without repairing the hole in the roof. The underlying problem with the student loan program – as evidenced by a failure that is a multiple of all other consumer loan products – is that it was incorrectly structured from the start.
Consider what the various relief plans introduced by the Department of Education for financially distressed borrowers do: they extend the duration of the loan – often to double the original 10-year period – reducing monthly payments to a more affordable level relative to income. But because this is also a cumbersome and confusing process, many borrowers who would otherwise benefit from such plans does not end up being helped, as criminal statistics confirm.
Instead of nickel-dampening this trillion-dollar problem by continuing to deal with it on a one-to-two basis, the entire portfolio of Federal Direct loans should be restructured so that the duration doubles, whether repayment has begun or not. In other words, what was once a 10-year period should now be extended to 20 years, and what is now a seven-year remaining duration should be extended to 14 years.
The personal budgetary implications of this move would be meaningful, especially for recent college degrees.
For example, according to the Department of Education’s Federal overview of student support portfolio, the average student loan balance is $ 36,635. At the current interest rate for unsubsidized Federal Direct loans, the monthly payment is $ 380.21 for the normal term of 120 months (10 years).
However, when this period is extended to 240 months (20 years), the monthly payment is reduced by almost 40 percent to $ 232.36 – a decrease of $ 148 that can spell the difference between financial self-sufficiency and parental dependence.
The disadvantage, of course, is that the longer the duration of the loan, the greater the total interest paid over the extended period. Therefore, Biden’s restructuring should also include a free prepayment option for those who can afford to continue transferring higher monthly payments.
Finally, all derogatory credit reporting data for this category of consumer debt must be removed once the restructuring is completed. Although no one twisted their arms to borrow the money, student debtors should not continue to be punished for the inappropriate loan structure they were forced to accept for an education that only a few are able to pay without help.
All in all, one checks all these fields by taking this approach:
- Those who do not need help can choose to give up without punishment.
- Taxpayers are not unreasonably burdened because the loans have a greater chance of being repaid in full.
- There are no negative tax consequences or long-term credit errors.
- There is no moral danger because the government is correcting its own mistake.
One more thing.
Trees do not grow up to the sky. Given the rapidly escalating level of federal debt and despite the self-liquidating nature of education loans, the federal government may at some point choose not to continue in the leading lending role for this program.
In that case, and only after the loans have been properly restructured, the department may choose to divest all or part of its portfolio to the private sector. Such a move would result in a reduction in the dollar-to-dollar federal deficit when the proceeds from these sales are used to extinguish the accompanying debt.
Financially distressed borrowers would also come forward because their recently extended loan period prolongs the need to ask for relief to hitherto frustrating not responding student loan administrators.
The only preliminary is that the government’s existing payment guarantee due to the unsecured nature of these debts would have to remain in place, as it has done for the discontinued Federal Family Education Loan program owned by the private sector – of which approx. 246 billion $ remains excellent.
But it is certainly a fair trade to beat in comparison to the cost of the general amnesty approach that some policy makers are in favor of.