This summer, my daughter will emerge from graduate school with a master's degree in counseling and $25,000 in student loans. That's a lot of money--except that she may never have to pay it all back. Current rules allow her to make modest monthly payments for 25 years and then forgive the remaining balance with no adverse effects on her credit rating. Uncle Sam will, in effect, make her a $23,500 gift.
Should I rejoice in my daughter's financial windfall? Or should I put on my citizen's hat and wonder why my taxes are underwriting this sort of giveaway?
My dilemma stems from the section of the federal student financial assistance programs known as Income Contingent Repayment. Under this option, monthly loan payments are tailored to former students' ability to pay and can be set as low as $5 (or zero if you are earning wages below the official poverty rate). ICR was enacted by Congress in 1993 as a cornerstone of President Clinton's new direct loan program.
Now that Congress is preparing for a new debate over college affordability (with the Higher Education Reauthorization Act of 1998), legislators have a ready-made opportunity to address ICR's shortcomings.
Few can quarrel with the intent of it. Linking repayment schedules to "ability to pay" constitutes an incentive for students to enter low-paying but socially useful professions such as teaching, and it provides a safety net for graduates who encounter unforeseen financial difficulties. The problems arise with the way ICR has been implemented. Let me illustrate by the case of my daughter.
Let's assume that she takes a starting job in a social service agency that pays $15,000 a year and that her income rises by 5% a year over the next 25 years to $48,378. If the interest rate on her $25,000 in loans stays at 8.25%, she will pay $56,511 in interest and principle, but she will still owe an additional $23,500. That's the "gift" that she will receive from American taxpayers.
This arrangement is definitely a good deal for my daughter, even though she may still have to pay $3,525 in income tax on the amount that is forgiven. Not only is she getting a substantial write-off, but her monthly payments, which start at $118.50, will never rise higher than $224. As a proportion of her adjusted earnings, these payments will actually fall from a high of 10.6% to 5.6% as her income rises. Under ICR, repayments need not even cover monthly interest payments. This results in what is known as "negative amortization"--where unpaid interest is added to principal.
By using such relaxed repayment schedules, Congress compromises the laudable principle of "ability to pay." If the proportion of income devoted to loan repayment held steady at a manageable 10.6% as her income rose, my daughter would actually pay off the loan one year early--within 24 years--and need no largess.
Another problem with ICR as it is currently implemented is that it reinforces the pernicious trend toward reliance on debt in financing American higher education. Debt levels of college graduates have reached the point where they are driving career choices and forcing married couples struggling with college debts to postpone taking on mortgages and saving for their own children's education.
ICR exacerbates these trends by creating incentives for students such as my daughter to borrow as much as they can. That's because the more she borrows, the greater the government subsidy and the less she pays for each subsequent dollar that is borrowed on a present value basis. If she increased her ICR loan from $25,000 to $30,000, she would be paying only 46 cents on the dollar on the additional $5,000. If she raised it to $35,000, she would be paying 34 cents on the last $5,000.
ICR also encourages new borrowing by students who are known credit risks. Under the direct loan program, students who have previously defaulted on loans can now consolidate their debts under ICR to avoid stiff penalties and climb back on the borrowing merry-go-round. Over the past five years, Congress has made great strides in reducing the default rate on student bank loans (from 22.4% to 10.4%). Loopholes in the ICR program could easily erase these gains. Such problems have no doubt compounded the huge backlog that recently shut down the direct loan consolidation program.
So how can Congress protect the worthy principle of "ability to pay" without making unnecessary demands on taxpayers? The easiest and most obvious step is to correct the error in the repayment schedule so that loan repayments will rise--or at least stay constant--as a proportion of borrowers' rising incomes. Other steps also can be taken:
* If the goal of ICR is to encourage students to enter low-paying but socially useful professions, the rules could be rewritten to target these fields. The plan is now accessible to everyone.
* Establish a minimal threshold for repayment--certainly high enough to cover interest costs and to avoid negative amortization.
* Make the repayment mechanism simple. Instead of using a complex formula to calculate payments, let's tell students that they will be expected to pay back a certain proportion of their income. That's something everyone can understand.
Federal tuition assistance is an important part of the investment that we as a country make in turning out educated workers and citizens, and there are times when outright subsidies are in order. When it comes to giving gifts to my daughter, however, I'd rather do it directly instead of relying on Uncle Sam as the middleman.