Defaulting on a student loan is not pleasant. It wrecks a borrower’s credit, puts her into the unpleasant world of debt collection, and can even result in wages or Social Security benefits being garnished. There are increasing calls to keep down student debt and to create more flexible payment plans to avoid default.
If we care so much about student loan debt, then it’s time to end the existing two-tiered system of handling students who default — one that doubles down on struggling borrowers by inflating the balances they owe, and another that helps them get a fresh start at a much lower cost.
The disparity in the treatment of students who default is a remnant of old rules governing federal student loans. Until 2010, loans operated through two different systems: a bank-based one, in which private companies like Sallie Mae issued loans that were guaranteed against default by the federal government, and the direct-loan program, where funds came straight from the U.S. Department of Education.
One of the main reasons the Obama administration ended the bank-based system for new borrowers midway through the president’s first term was that both programs provided the same benefits, but it was cheaper to administer the one that didn’t involve banks.
It turns out the benefits weren’t actually the same. Borrowers who struggle or go into default are much better off in the direct-loan program run by the Education Department.
Here’s why. The government offers a one-time option to students who default to rehabilitate their debt. To do so, a borrower must make at least nine on-time payments within 10 months. When a direct-loan borrower does that, the debt goes back into active repayment and is transferred back to a student-loan servicer.
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The cost of loan rehabilitation in the direct-loan program is fairly small for the borrower. She loses about 20 percent off each of the nine payments. That’s it. While the department has the ability to attach additional collection costs, it does so sparingly.
In the bank-based system, meanwhile, rehabilitation is more complicated. That’s because when a loan defaults it ends up in the hands of a nonprofit or public entity known as a guaranty agency. These middlemen use federal dollars to cover the vast majority of lenders’ losses on a loan default and then work with the borrower to get her back into repayment.
Borrowers rehabilitating their loans through a guaranty agency end up paying a lot more. Some terms are the same — they also lose about 20 percent of each payment to collection costs. But once borrowers have made the nine qualifying payments to rehabilitate the loan, the agency can also tack on up to 16 percent of the unpaid loan’s balance in collection costs. So if a borrower was already struggling with a $10,000 debt, they’ll suddenly be facing a balance of $11,600 after rehabilitating. The fresh start comes with greater debt.
That’s a significant financial difference between the two loan programs. Let’s say that the same borrower with $10,000 in default makes nine payments of $120 to rehabilitate. The 20 percent of $1,080 is just $216 — a fraction of what he would be facing in the bank-based system.
The inflated cost for rehabilitating bank-based borrowers is actually lower than it used to be. Until 2013, a guaranty agency could charge borrowers up to 18.5 percent in collection costs, and the guarantor also got to keep another 18.5 percent of the loan instead of giving it back to the government. A bipartisan budget agreement in December 2013 took away the second 18.5-percent commission and reduced the collection costs to the current level of 16 percent.
The discrepancy in collection costs is similar for borrowers who seek to get out of default by consolidating their loans. A borrower in the bank-based system is hit with collection costs of up to 18.5 percent of their balance. While the department could charge this amount, a direct-loan borrower who consolidates out of default is typically charged collection costs of just under 3 percent of their loan balance.
Default Horrors Compounded
The continued disparity in costs for defaulted borrowers is doing nothing but lining the pockets of guaranty agencies. In the case of the guaranty agency known as the Educational Credit Management Corporation, or ECMC, all that money from defaulted borrowers is what financed the company’s acquisition of 40,000 students from troubled Corinthian Colleges. And that’s to say nothing of the feeling of hopelessness it must give borrowers to see loan balances suddenly grow by thousands of dollars.
Fortunately, this problem has a limited shelf life. No new bank-based loans have been made since 2010, and the volume in the program is shrinking over time, meaning that new borrowers do not have to worry about these steeper fees. And it’s further proof that the switch to having the Education Department directly handle all loans continues providing unexpected benefits to borrowers.
But millions of borrowers have seen their default horrors compounded and exacerbated over the years by inflated collection costs. And borrowers who still hold $387 billion in older loans could face trouble.
It’s possible the Department of Education could fix the problem right now. Existing regulations allow the secretary to remove loans from a guaranty agency’s control. The department has to show that doing so is in the federal fiscal interest, which might be limiting. But one has to think that saddling struggling borrowers with thousands of dollars in additional costs for no good reason must surely affect borrowers’ ability to repay their loans — the outcome that should ultimately matter most.
Defaulting on a student loan is bad enough. It’s time to at least reduce the burden on those borrowers holding older loans who are stuck getting a worse deal.