A New Way To Pay Student Loans: Slowly or Not At All

Uncle Sam has yet another program out to help distressed borrowers. This one bails out anyone with more federally-sponsored student loans than they can afford. Instead of repaying your student loans on a usual time- and interest-based schedule, the government is allowing people to pay based on income. It's an interesting idea, but I worry it could have some bad consequences.

Here the gist of the program, according to an article in the San Francisco Chronicle:

The new program sets monthly payments based on adjusted gross income and family size. Unpaid principal and interest is generally added to your loan amount. Any debt remaining is wiped out after 25 years - or after 10 years if you work in the public or nonprofit sector.

Turning Incentive On Its Head

The article notes:

If you are unemployed, low-income or have a very large debt, you could qualify. "People who need advanced degrees to get low-paying jobs" are prime candidates, says Edie Irons, a spokeswoman for the Project on Student Debt.

Before this program, having a large student loan balance produced a pretty obvious outcome: graduates sought jobs paying enough money to cover those loans. This is the kind of incentive that makes a capitalist economy go around. Young adults want to earn good salaries anyway, but having a pile of college debt certainly enhances that incentive.

Now, however, the incentive from college loans has changed: the more college loans you have, the less incentive you have to earn a high income. I did some calculations based on the IBRinfo website (where you can learn more about the program). If you have $40,000 in federal student loans with an interest rate of 2.5%, here's your annual savings through the plan versus what you would have paid before:

As you can see, the less you make, the more the government rewards you. And if you make less for a really long time, then eventually, the government will wipe any remaining unpaid debt away entirely.

Don't get me wrong: any rational person would still rather be making $200,000 per year with full student loan payments than $16,000 per year to save a few thousand dollars through this program. After all, our progressive tax system hasn't managed to destroy incentive to earn higher income. Yet, it does seem like young people fresh out of college or graduate school will feel more comfortable making lower salaries. If you only worry about the stress debt can create, then that's fine. But if you believe salary is linked to productivity, then you might not be as comfortable with this outcome.

Wacky Mortgage Student Loan Products?

Remember all of those absurd subprime mortgage products you heard about a few years back? Some were even crazier than the standard adjustable-rate mortgages. The really insane ones involved something called negative amortization. In English, that means mortgage-holders paid less each month than they were charged in interest, causing their mortgage balance to grow instead of shrink. Eventually the payment would increase. I'm not sure how such a product ever makes sense, but the notion must have been that these homeowners would refinance the loan eventually or earn a higher income once the payment increased.

Rather than learn from this mistake, this student loan program seeks to emulate it. Edie Irons, a spokeswoman for the Project on Student Debt, explains in the article:

The main downside of the new program: "Like any plan where you pay less than the full amount, you could end up paying more interest over time," Irons says.

I created another scenario. This time, imagine someone who graduates from an expensive private university with a PhD in social work, earning $22,000 per year with $100,000 in college debt at 2.5%. I'm assuming a 10% raise each year. This amounts to a negative amortization loan. Here's what the principal balance looks like for 10 years:

At first, the principal balance increases for several years. Then, around year five, it finally begins to dip below the original balance of $100,000. After ten years, this person has only paid off about $15,100 of the student loans, leaving a balance of around $84,900.

But this has a feature those wacky mortgages didn't: under this program, assuming that social work is considered "public or nonprofit," Uncle Sam takes care of the debt after ten years. That's great news for the social worker, but not such great news for taxpayers. The program amounts to the government subsidizing private universities.

Higher Education Costs

I also suspect another unexpected outcome of this program: higher costs for secondary education. Right now, the demand for expensive education has something holding it back -- people who don't want to be deep in debt. But if there's less concern about student loan costs, then demand for more expensive education should increase. That increased demand will drive up prices, since people will be willing to pay more, as the actual cost to them might be less.

More College Loans

Finally, this program might have the odd effect of actually increasing the amount of student loans. Universities will probably feel less pressure to provide as much scholarship money. Student loan debt burdens will be easier for graduates to handle and sometimes vanish entirely. As a result, they will have an easier time convincing new students to take out more loans. This might be just in time for expensive private colleges to build back up their endowments after losing millions in the bad market.