The U.S. Should Adopt Income-Based Loans Now

Michael Morgenstern for The Chronicle

October 23, 2011

A new generation of student debtors has seized the public stage. While the demands of the Occupy Wall Street movement are many, college lending reform is near the top of every list. Decades of greed, inattention, and failed policy have created a growing class of young men and women with few prospects of landing jobs good enough to bear the weight of their crushing college loans.

Some activists have called for wholesale student-loan forgiveness—a kind of 21st-century jubilee. That's unlikely. But there's something the federal government can do right now to help students caught by our terribly unjust higher-education financing system: End all federal student-loan defaults forever by moving to income-contingent loans.

The concept is simple. Right now, students pay back their loans on a fixed schedule, typically amortized over 10 years. Since people usually make less money early in their careers, their fixed monthly loan bill is hardest to manage in the first years after graduating (or not) from college. People unlucky enough to graduate during horrible recessions are even more likely to have bad jobs or no jobs and struggle paying back their loans. Not coincidentally, the U.S. Department of Education recently announced a sharp rise in loan defaults.

Under an income-contingent loan system, like those in Australia and Britain, students pay a fixed percentage of their income toward their loans. Payments are automatically deducted from their paychecks by the IRS, just like income-tax withholding. Self-employed workers pay in quarterly installments, just as they do with their taxes. If borrowers earn a lot, their payments rise accordingly, and their loans are retired quickly. If their income falls below a certain level—say, the poverty line—they pay nothing. After an extended time period of 20 or 30 years, any remaining debt is forgiven.

In other words, nobody ever defaults on a federal student loan again. The whole concept of "default" is expunged from the system. No more collection agencies hounding people with 10 phone calls a night. No more ruined credit and dashed hopes of home-ownership. People who want to enter virtuous but lower-paid professions like social work and teaching won't be deterred by unmanageable debt.

And by calibrating interest and payment rates, the federal government can make the program no more expensive than the current cost of subsidizing loans and writing off unpaid debt. The only losers are the repo men.

The concept has been proven to work—Australia and Britain have used it for years—and both liberals and conservatives have reason to get on board. The Nobel Prize-winning economist Milton Friedman proposed the idea all the way back in 1955.

Indeed, income-contingent loans are such a good idea, one might wonder why they don't exist already. Historically, administrative complications have been a major culprit. Until last year, the federal government managed most student loans by paying private banks to act as lenders and then guaranteeing their losses. The IRS would have had to maintain relationships with scores of different lenders, relying on banks for notification of who owes how much and disbursing money hither and yon. Income-contingent loans would have created a huge bureaucratic headache.

But in 2010, Congress abolished the old system, cutting out private banks. Now the federal government originates all federal loans. The IRS would have to deal with only one lender: the U.S. Department of Education. In other words, there is a new opportunity to overhaul the way students repay their college debt that didn't exist until this year.

It's true that students who pay over long periods of time will pay more interest, and that the taxpayers will bear the cost of partially forgiven loans. But under the current system the federal government is already eating the cost of defaulted loans, and low-income students who can't repay loans are often hit with fines and penalties that dwarf the cost of extra interest.

When federal loans were first created, nobody imagined they would become standard practice for financing college. As late as 1993, most undergraduates didn't borrow. Now, two-thirds take on debt, and most of those loans are federal. The average debt load increased over 50 percent during that time.

Nor is repayment an isolated problem. One recent study found that the majority of American borrowers—56 percent—struggled with loan payments in the first five years after college. In Britain, by contrast, 98 percent of borrowers are meeting their obligations.

Because student loans can almost never be discharged in bankruptcy, defaulted loans can haunt students for a lifetime. Some senior citizens theoretically could have their Social Security checks garnished to make good on old student debt. That is insane.

A similar-sounding federal program, called income-based repayment, is now on the books and is scheduled to become somewhat more generous starting in 2014. But the program is administratively complicated, involving income-eligibility caps and requiring students to reapply every year. This points to another major advantage of income-contingent loans: simplicity.

Even with the government as the sole source of federal loans, many graduates still have to navigate a thicket of different rates, terms, lenders, consolidation options, and schedules in order to meet their obligations. Some fall behind not because they're unwilling or unable to pay, but because they can't get the right check to the right place at the right time. An income-contingent system would remove all of that hassle, making repayment simple and automatic, and setting college graduates free to get on with the important business of starting their lives.

The student-loan system has grown into an out-of-control monster tearing at the fabric of civil society. In Chile, student anger over an inequitable, unaffordable, profit-oriented higher-education system led to nationwide protests and violent confrontation just months ago. Now the seeds of similar unrest are sprouting here.

Income-contingent loans won't solve the escalating college prices, state disinvestment in higher education, and overall economic weakness that are driving more students into debt. But they offer a simpler, fairer, more efficient, and more humane way of allowing students to repay loans that aren't disappearing from the higher-education landscape anytime soon. They could be put in place quickly at no extra cost to the taxpayer. In a dismal fiscal environment, there are few deals this good.

The students at the barricades are right to be angry. They didn't run the economy into the ditch. They didn't create the system in which a college degree is all but mandatory to pursue a good career, and loans are often unavoidable. But they have to live with it. Income-contingent loans are one way to give them the help they need.

Kevin Carey is policy director at Education Sector, an independent think tank in Washington.