Student Loans Are Poorly Aligned With Graduate Earnings

Student-loan payments are the bane of many new graduates. A recent analysis by the Brookings Institution explains why: The typical new graduate is likely to devote 14 percent of his or her paycheck to student loans. That’s about half of what the average American spends on housing each month.

It’s even worse for students who graduate with fine-arts or therapy degrees. They can expect to put more than 20 percent of their pretax income toward paying off student loans. Good news for nursing and engineering majors, though. They’ll need to dedicate less than 10 percent of their initial income to student loans.

Of course, over the typical 10-year repayment plan, those percentages should drop for most graduates. According to the Brookings analysis, the share of a typical graduate’s income devoted to student-loan payment drops to 6.5 percent a decade after graduating.

That’s because the median graduate’s earnings climb 65 percent in the five years following graduation, the researchers found, while student-loan payments stay fixed. For many graduates, that pay jump makes hefty loan repayments more manageable.

A lower percentage of income going toward student-loan repayment might help a recent graduate make ends meet, but it’s still a substantial burden. For comparison, the most recent U.S. Bureau of Labor Statistics’ Consumer Expenditure Survey reports that the average person in 2013 spent 7.1 percent of his or her income on health care, 17.6 percent on transportation, and 33.6 percent on housing-related expenses.

Possible Solution; Restructure Repayment

It might be better for graduates, the Brookings study’s authors say, to structure student loans so they aren’t so burdensome immediately after graduation.

“The timing of paying back the debt, and the payoffs or benefits of college are off,” says Brad Hershbein, a researcher at the Hamilton Project, an economic-policy initiative at Brookings, and co-author of a report on the study.

College graduates pay off almost all of their debt during the first 10 years after they graduate, when they have the lowest income of their career. An income-based repayment plan might make more sense, Mr. Hershbein says, especially for those whose degrees pay less out of the gate but increase over time. For example, such a plan could benefit graduates who majored in art history and criticism and who face initial loan payments equal to about 16 percent of their median earnings before dropping to 8 percent a decade after graduation.

But for mechanical-engineering majors, the traditional repayment method may make more sense because the median graduate will put about 7 percent of his or her income in the first year toward student loans.

That’s because income-based repayment plans come with a big downside: Graduates end up paying more interest.

To help students figure out which plan would be best for them, the Hamilton Project created an interactive calculator.

Students enter their majors, projected student-loan debt, and interest rates on their loans. The calculator then shows how much of the income earned by a typical graduate with that major will go toward student-loan payment.

Business Cycles Can Play a Role

However, the calculator cannot take into account economic shifts. The timing of a student’s graduation and the economy the student graduates into can have a major impact on what repayment plan makes the most sense. For example, the median annual earnings for 25-to-34-year-olds with bachelor’s degrees was $55,000 in 2007 (adjusted to 2012 dollars). However, as the economic downturn worsened, wages fell for four straight years, and as of 2012 earnings for that group were $8,000 below pre-recession levels, based on data from the National Center for Education Statistics.

As a result, people who graduated during that period probably devoted a higher percentage of their income to student-loan repayment (on top of lower career earnings).

The Rise of Income-Based Repayment Plans

Income-based repayments plans are increasing in popularity, according to the Education Department. The latest data show that in the 18 months from April 1, 2013, to September 30, 2014, participation in the federal Income-Based Repayment plan more than doubled, to $102.5-billion in loan volume.

During that same span, the number enrolled in the Pay as You Earn program grew eightfold, to 320,000 direct-loan borrowers, with $12.2-billion in outstanding debt.

President Obama expanded the Pay as You Earn option in 2011 to include more graduates who face financial hardship. Qualified graduates can have their student-loan payments capped at 10 percent of their discretionary income and, depending on qualification, can have the loans forgiven after 20 years. There is also the Income-Contingent Repayment plan, which is a income-based repayment plan that does not have a not have an initial income eligibility requirement.

None of the plans cap private loans, and most Parent PLUS loans are not eligible.