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Would Forgiving Student Loans Stimulate the Economy?

Would Forgiving Student Loans Stimulate the Economy?

Mark Kantrowitz / Publisher of FinAid and FastWeb

August 24, 2009

Forgiving All Student Loans is Poorly Targeted

Forgiving all debt provides a financial windfall to borrowers who are capable of making their monthly loan payments, such as wealthy doctors and lawyers, and not just to borrowers who are experiencing financial difficulty. There are more effective and better-targeted ways of spending taxpayer money.

Consider, for example, income-based repayment. This repayment plan, which became effective on July 1, 2009, caps monthly payments on federal student loans at 15% of discretionary income, where discretionary income is defined as the amount by which adjusted gross income exceeds 150% of the poverty line. Borrowers with income near or under the poverty line have a zero payment. After 25 years, any remaining debt is forgiven. When used in conjunction with public service loan forgiveness, the debt is forgiven after 10 years. For most borrowers who use income-based repayment, the monthly payments will be less than 10% of gross income.

Congress enacted income-based repayment and public service loan forgiveness as part of the College Cost Reduction and Access Act of 2007 to help people who want to pursue careers in public service but who are prevented from doing so because public service jobs do not earn enough income to repay the debt. Public defenders and prosecutors often accumulate $120,000 or more in debt obtaining a law degree, but face starting salaries of about $40,000. A debt-to-income ratio of 3 or more is unsustainable and leads to high turnover in these positions. But with income-based repayment the monthly payment is cut by 3/4 to 3/5 (for this particular combination of debt and income) making it possible for public-spirited lawyers to remain in public service, and the 10-year forgiveness ensures that they are not in debt forever.

There are Better Ways of Spending Taxpayer Money

A better approach is to target the spending in a means-tested manner. Lower income students are much more likely to spend a windfall than to save it. Increasing federal need-based grants, for example, would not only help low income students enroll in college, but would also stimulate the economy because nobody saves the Pell Grant. $35 billion a year would be enough to eliminate education loans from the financial aid packages of low income students by doubling the maximum Pell Grant. Not only would that translate into an immediate spend, but it would increase the number of low income students graduating with Bachelor’s degrees by 170,000 to 320,000 a year. The increased federal income tax revenue from these graduates would pay for the cost of the increased grants in less than a decade, a pretty good return on investment.

Or if the goal is to provide relief to existing borrowers, why not roll back the changes to the bankruptcy code that prevent borrowers from discharging federal and private education loans? There is at best weak justification for the exception to discharge for private student loans. Some people might argue that federal education loans should be excepted from discharge because the federal loans provide a variety of options for relief for borrowers in financial distress, such as economic hardship deferments, death and disability discharges, extended repayment, and the new income-based repayment plan mentioned earlier. (Though the total and permanent disability discharge for federal education loans is not aligned with the definition of disability used for Social Security, preventing some disabled borrowers from getting their loans discharged.) Private student loans offer none of these consumer protections and are little different than credit cards, which are dischargeable in bankruptcy. It seems strange to lump private student loans in with taxes, luxury goods, child support, alimony, DUI, criminal fines and other nondischargeable debts. Lenders have argued that repealing the exception to discharge for private student loans would make the loans less available and increase the costs. But the loans are already less available and more expensive, and permitting bankruptcy discharge would likely increase the fees by no more than 1%. Representative Danny K. Davis proposed legislation in 2008 to allow private student loans to be discharged after five years in repayment. (Senator Richard J. Durbin proposed eliminating the exception to discharge for private student loans entirely.) This seems like a reasonable compromise, and is similar to the bankruptcy code provisions for student loans from its inception in 1978 to 1990. (The five year threshold was replaced with a seven year threshold from 1990 to 1998 when it was removed.) Unfortunately, Rep. Davis’s amendment failed in the House by a vote of 179 to 236. But perhaps the legislation could be reintroduced during the current session of Congress.

Mark Kantrowitz is a nationally recognized financial aid expert and publisher of FinAid.org and FastWeb.com.