The Case for Rapid Repayment of Student Debt

New entrants to the workforce need to prioritize student debt reduction over contributions to 401(k) plans.

The first of eight essays in my new paper Financial Decisions for a Secure and Happy Life makes the case that new entrants to the workforce must often delay savings for retirement to quickly eliminate most if not all their student debt.  There are several reasons for this finding.

Reason One:  Failure to reduce student debt to a manageable debt level often leads to poor credit and higher borrowing costs on auto loans, credit cards, private student loans, and mortgages.

Reason Two:  A person using a short maturity loan will pay substantially less in interest than a person using a long maturity loan.

Reason Three:  The decision to enroll in an Income Driven Repayment loan and only pay the minimum balance will often result in increased loan balances and substantially higher lifetime interest payments. 

Reason Four:  The quick reduction of student debt frees up cash for other financial priorities including increased savings for retirement.

Reason Five:  Most young student borrowers choosing to immediately save for retirement on their first job will raid their 401(k) plan and pay tax and penalty.

Reason Six:  The rapid elimination of student debt facilitates the purchase of a first home, lower mortgage costs, and higher house equity, an important source of wealth. 

The succinctly written eight essays in  Financial Decisions for a Secure and Happy Life can be obtained for $7.00.  I suspect you will find the financial strategies and tips outlined there worth much more.

Analysis of the Abraham and Strain Student Debt Argument

A recent article authored by Abraham and Strain arguing against a debt relief proposal under consideration by the Biden Administration was inaccurate. The proposal under consideration mostly benefits middle-income borrowers and the program could be means tested. Existing IDR programs have proven to be ineffective. Bankruptcy reform won’t pass Congress. Student debt discharge is the only realistic way to stop the increase in student debt burdens and reduce the number of people foregoing higher education.

Introduction:

Abraham and Strain claim a debt relief proposal for student borrowers considered by President Biden is regressive.  They cite research indicating that a blanket forgiveness of $10,000 in student debt relief would offer $3.60 in debt relief to households with the highest 10 percent of income compared to $1.00 for the bottom 10 percent.  The research they cite also found that ¾ of the benefit from the proposal under consideration would flow to households with income over the median.  They argue that expansion of Income Driven Replacement (IDR) loan programs and alteration in the treatment of student debt in bankruptcy would be a more effective way to assist students with excessive student loans.

Comments on arguments advanced by Abraham and Strain:

I am not surprised that student debt does not provide much benefit to households with income in the bottom ten percent because education is the best way to avoid poverty. Most of the advantages of the current student loan discharge proposal appear to go to middle income people with income between the 25th and 75thpercentile.  The percent of people receiving benefits in the middle of the income distribution is a much more interesting portrayal of the equity of the proposal than the percent of benefits going to people with income over the median. 

IDR programs have proven to be ineffective at providing debt relief to student borrowers, especially middle-income borrowers.  The Public Service Loan Forgiveness loans, which are tied to IDR loans were not discharged in a timely fashion and it is likely that borrowers in long-term IDR programs will experience a similar fate.  People in IDR loan programs often can’t qualify for a home mortgage because of uncertainty about their income and loan payment. The relative merits of an IDR versus a conventional loan are unknowable immediately after the student borrower finishes school and starts repayment.  IDR loans can be negatively amortized, and many IDR borrowers pay substantially more on their loan than if they took out a conventional loan.

Abraham and Strain argue for allowing the discharge of student loans in bankruptcy, an action that would not pass Congress.  Alternatively, it would be useful to modify chapter 13 bankruptcy payment rules to allow for increased student debt payments and decreased payments on other consumer loans during the chapter 13 bankruptcy period.  This proposal also probably lacks the 60 votes needed to get through the Senate. 

Abraham and Strain argue that it is inappropriate to treat student borrowers from people who borrowed for other purposes.  However, this is exactly what current bankruptcy law does and Congress is not going to change this situation.  A second-best answer is to provide debt relief.

The $10,000 immediate student loan debt discharge strikes me as excessively generous.  I agree that it could encourage increased future borrowing.  I would structure debt relief at the greater of 20 percent of outstanding loans per year or $3,000 per borrower per year for five years.  I would exclude borrowers with household income greater than the 90th percentile.

Concluding Remark

These has been a constant increase in the trend growth of the number of entrants to the workforce with student debt, the average student debt burden for new workers, and the number of older workers leaving the workforce and entering retirement with unpaid student loans. 

I understand that most people with student debt are better off than people who never went to college but increases in the burden of going to college will almost certainly increase the number of people foregoing higher education.  Congress is not going to act on this problem.  Many of the proposed solutions won’t work.  Some unilateral debt relief is the only way to avoid worsening debt burdens and increases in the number of people foregoing higher education.

David Bernstein, an economist living in Denver Colorado is the author of A 2024 Health Care Reform Proposal.  Use promotion code REFORM101 for a discount on the paper.

Student Debt Proposal #4: Reducing tradeoff between retirement saving & student debt repayment

Reforms centered on increased use of Roth IRAs would better balance saving for retirement and student debt repayment than the Secure Act 2.0 reforms.

Introduction:   Tax and financial incentives are more generous for contributions to 401(k) plans than for the repayment of student debt.

  • Workers are allowed to to save untaxed dollars in a firm-sponsored retirement plan or an individual retirement account.
  • Firms can match employee contributions to the 401(k) plan. Two common 401(k) matching formulas are 50 percent of the dollar amount contributed by the employee up to 6.0 percent of the employee’s salary and 100 percent of contributions up to 3 percent of the employee’s salary. 
  • Student borrowers can deduct up to $2,500 of interest on student loans.  
  • The student loan tax deduction pertains exclusively to interest while the entire 401(k) or IRA contribution is exempt from taxes.
  • There are no matching contributions for student loan repayment.

The decision to prioritize 401(k) contributions over student debt repayment does not always work out well as discussed in a previous post.  Potential consequences include:

  • Higher total loan payments associated with selection of longer loan maturities.
  • Higher borrowing costs stemming from higher debt levels and lower credit ratings.
  • Early disbursements of 401(k) funds leading to penalty and tax payments.
  • Increased likelihood of having debt obligations in retirement.

Student borrowers who quickly repay their loans would increase saving for retirement, realize lower borrowing costs, start the process of paying off their mortgage and would basically be much better off.  

There is general agreement that student debt significantly impedes saving for retirement by young households.  There is, however, no real consensus on how to fix this problem.

Proposed modifications to 401(K) plans in the SECURE Act 2.0, which would induce some student borrowers to begin saving through a 401(k) plan, don’t solve this problem. Expanded incentives for the use of Roth IRAs by student borrowers would be far more effective than expanded incentives for 401(k) contributions.

The Secure Act 2.0:

Wall Street favors and greatly benefits from incentives for 401(k) investing. The Secure Act 2.0 maintains the high priority attached to 401(k) saving and facilitates participation in 401(k) plans by student borrowers.  

The Secure Act 2.0 has the following features:

  • Requires automatic enrollment of employees in 401(k) plans
  • Requires all catchup contributions be designated as Roth contributions
  • Allows designation of matching contributions to a Roth account 
  • Delays mandatory distributions
  • Reduces waiting period for 401(K) contributions from 3 to 2 years for part-time workers.
  • Authorizes 401(k) matches for student borrowers even if they do not participate in a 401(k) plan.

The general purpose of the Secure Act 2.0 is to expand investments through 401(k) plans.

Many people who rely on high-cost 401(k) plans often end up paying a substantial portion of their savings to Wall Street. Go here for a discussion of the impact of 401(k) fees on retirement. 

The proposal only benefits student borrowers at firms with 401(k) plans, workers at firms with plans offering matching contributions, and workers eligible for the 401(k) plan.  

Many student borrowers will not benefit from this provision in Secure Act 2.0 including:

  • Self-employed workers and people employed by firms not offering a 401(k) plan.  Only 53 percent of small and mid-size firms offer a 401(k) plan.
  • People at firms with 401(k) plans that do not match employer contributions. Around 49 percent of all firms do not offer an employer match.
  • Employees who are ineligible for the firms-sponsored 401(k) plan.  Around 24 percent of firms require one year of service for entry to the firm-sponsored 401(k) plan.
  • Employees eschewing 401(k) plans due to  vesting requirements.

It is reasonable to anticipate that increased 401(k) contributions by young adults with student debt will fail to increase retirement wealth because, as evidenced by this CNBC article, around 60 percent of young adults end up raiding their retirement savings earlier in the career.

An Alternative Proposal, Incentives for Increased Use of Roth IRAs:

A more equitable and efficient way to balance the goal of saving for retirement with rapid repayment of student debt is through incentives to increase contributions to Roth IRAs instead of 401(k) plans

This could be accomplished by modifying the SECURE Act in the following fashion.

  • Mandate automatic contributions to Roth IRAs instead of automatic contributions to 401(k) plans 
  • Mandate automatic use of low-cost highly diversified IRAs unless person opts for a different investment strategy
  • Allow employers to match contributions to Roth IRAs or contributions to 401(k) plans
  • Allow employers to give employer matches to holders of Roth IRAs even if the student borrower does not contribute to the Roth IRA.
  • Prohibit distributions from investment income inside Roth IRAs prior to age 59 ½. 

A strong case can be made that many workers should maximize the use of Roth IRAs instead of traditional IRAs even under current law.

  • There are substantial tax savings in retirement from the use of Roth IRAs from two sources. First, the distribution for the Roth IRA is not taxed during retirement.  Second, the Roth distribution does not count towards the income limit leading to the taxation of Social Security benefits.  Households that rely primarily on Roth distributions in retirement often do not pay any tax on their Social Security benefits.
  • Distributions from Roth contributions prior to age 59 ½ are not subject to income tax or penalty.  This feature benefits young adults who tend to raid their account prior to retirement and pay taxes and penalty.
  • The Roth account does not allow 401(k) loans, a feature that causes people to distribute funds and even close the entire account prior to retirement. 

This proposal encourages student borrowers who are ready to save for retirement to choose a Roth IRA instead of a 401(k) plan.  The change will increase retirement saving for several reasons

  • Some firms without a firm-sponsored retirement plan may provide an employer match to an IRA because there should be no administrative costs imposed on the firm for this type of contribution
  • The automatic selection of a low-cost IRA will usually result in lower fees and higher returns compared to the default 401(k) option. 
  • The restriction on distributions from investment income until after age 59 ½ prevents people from distributing all retirement assets and closing the retirement plan prior to retirement. 
  • The IRA could receive matching funds from multiple employers.

Both the Secure Act 2.0 reforms and the alternative one presented here favor Roth accounts over traditional accounts.  The use of Roth accounts favors low-income student borrowers because their marginal tax rate and deduction for contributions to traditional 401(k) plans is low.  

The use of Roth accounts by low-income low-marginal-tax-rate workers facilitates diversion of some assets for debt repayment because the holder of the Roth requires less wealth to fund a sufficient retirement.  

Concluding Remarks:  Wall Street and financial advisors consistently advise their clients to prioritize 401(k) contributions over rapid repayment of student debt.  This approach is not leading to a secure financial life for many student borrowers who are paying more on student debt over their lifetime, incurring high borrowing costs on other loans, having trouble qualifying for a mortgage and raiding their 401(k) plan prior to retirement.   The use of Roth IRAs and rules allowing employers to match contributions into a Roth rather than contributions into a 401(k) will help student borrower better balance student debt repayment and retirement saving.

The more rapid repayment of student debt might also be facilitated by a partial discharge of student debt after around 60 on-time payments as describe in this post.

A list of student debt post presented here will be updated with new articles when available.

Overview of student debt reform proposals

Most discussion on student debt involves debates over the desirability of free college and large-scale debt discharge programs. The proposals listed here involve a wider range of policy levers.


Student Debt Proposal #1: Eliminate First-Year Debt

The reduction of student debt taken on by first-year students through a combination of additional first-year financial assistance and restrictions on first-year loans would be an effective way to reduce total debt incurred by student borrowers.  This policy would also provide large benefits to students susceptible to payment problems because they did not finish their degree.  Go to this post for a more thorough discussion of a proposal to eliminate or substantially reduce debt incurred during the first year of college.

Student Debt Proposal #2:  Potential modifications to student loans

Existing programs designed to provide student borrowers debt relief are ineffective. Proposed reforms including — a relatively quick partial discharge of federal student loans, the elimination of interest charges on the maturity date of the loan, and the conversion of outstanding student debt at loan maturity to a tax liability collected by the IRS — would benefit both student borrowers and taxpayers.  Go here for a description of problems with existing student debt relief programs and my proposed reforms.

Student Debt Proposal #3: Facilitating on-time graduation

Students who fail to graduate on time take on high levels of student loans; hence, policies that improve on-time graduation rates would reduce student debt burdens.  There are multiple reasons why students fail to graduate on time and multiple ways to increase on-time graduation rates including — improvements in education prior to college, changes in college academic policies, and efforts to assist students dealing with hardships. Go herefor a description of polices designed to facilitate on-time graduation.

Student Debt Proposal #4: Reducing tradeoff between retirement savings & student debt repayment

Reforms centered on enhancing Roth IRAs and increasing incentives for the use of Roth IRAs would better balance saving for retirement and student debt repayment than the Secure Act 2.0 reforms that center on use of 401(k) plans. A first draft of a paper opposing the Wall Street view and suggesting new incentives can be found here

Coming Attractions: Forthcoming work on student debt includes — discussions of problems with public service loan programs and income based replacement loan programs, evaluation of potential regulation of private loans, the use of PLUS and parental PLUS loans, and treatment of student debt in bankruptcy.

Student Debt Proposal #4: Creation of incentives for more rapid student loan repayment

Financial incentives favoring contributions to 401(k) plan over rapid repayment of student loans make many households worse off financially. Programs and incentives encouraging the rapid repayment of student debt would lower future borrowing costs, facilitate the purchase of homes, and allow many households to increase saving for retirement.

Introduction:   Tax and financial incentives are more generous for contributions to 401(k) plans than for the repayment of student debt.

  • Workers are allowed to to save untaxed dollars in a firm-sponsored retirement plan or an individual retirement account.
  • Firms can match employee contributions to the 401(k) plan. Two common 401(k) matching formulas are 50 percent of the dollar amount contributed by the employee up to 6.0 percent of the employee’s salary and 100 percent of contributions up to 3 percent of the employee’s salary. 

The subsidies for 401(k) contributions are substantially higher than the subsidies for student debt repayments.

  • Student borrowers can deduct up to $2,500 of interest on student loans.  
  • The student loan tax deduction pertains exclusively to interest while the entire 401(k) or IRA contribution is exempt from taxes.
  • There is no matching contribution for student loan repayment.

The decision to prioritize 401(k) contributions over student debt repayment does not always work out well as discussed in a previous post.  Potential consequences include:

  • Higher total loan payments associated with selection of longer loan maturities.
  • Higher borrowing costs stemming from higher debt levels and lower credit ratings.
  • Early disbursements of 401(k) funds leading to penalty and tax payments.
  • Increased likelihood of having debt obligations in retirement.

Student borrowers who quickly repay their loans would increase saving for retirement, realize lower borrowing costs, start the process of paying off their mortgage and would basically be much better off.  

There is general agreement that student debt significantly impedes saving for retirement by young households.  There is, however, no real consensus on how to fix this problem.

A Congressional Proposal:

Wall Street favors and greatly benefits from incentives for 401(k) investing.   Current proposals to assist student borrowers favored by Wall Street and financial advisors maintain incentives for 401(k) contributions over rapid repayment of student loans.

The Secure Act 2.0 would expand incentives for 401(k) contributions.  One provision would allow student borrowers who are enrolled in a firm-sponsored retirement plan to receive a matching 401(k) contribution for funds used to pay off their student loan.  

It is not clear an act of Congress is needed to implement this proposal because of a previous IRS ruling.

The proposal should allow the employer to contribute an employer match to the employee’s 401(k) plan up to the smaller of the student loan payment and the maximum allowable match on the 401(k) plan.   The student borrower repaying her loan would receive the employer match even if the student borrower did not contribute to the 401(k) plan.

The proposal only benefits student borrowers at firms with 401(k) plans, workers at firms with plans offering matching contributions, and workers eligible for the 401(k) plan.

Many student borrowers will not benefit from this provision in Secure Act 2.0 including:

  • People at firms with 401(k) plans that do not match employer contributions. Around 49 percent of all firms do not offer an employer match.
  • Employees who are ineligible for the firms-sponsored 401(k) plan.  Around 24 percent of firms require one year of service for entry to the firm-sponsored 401(k) plan.

This proposal and other aspects of Secure Act 2.0 favor higher-cost 401(k) plans over low-cost IRAS.  People who rely on high-cost 401(k) plans end up paying a substantial portion of their savings to Wall Street. Go herefor a discussion of the impact of 401(k) fees on retirement.

Moreover, the use of traditional 401(k) plans instead of Roth IRAs substantially increases tax burdens in retirement. A strong case can be made that workers should maximize the use of Roth IRAs instead of contributing to traditional plans.  

A more equitable and efficient approach might provide additional retirement subsidies for people without access to 401(k) plans or might provide additional incentives for the more rapid reduction of student loans.

An Alternative Proposal

The current system, which incentivizes saving for retirement over rapid repayment of student loans, does not work for many households.  This is evidenced by a CNBC article that found that nearly 60 percent of young adults have taken funds out of their 401(k) plan.

The alternative proposal presented here incentivizes the more rapid repayment of student loans over saving for retirement.  Under the alternative approach, the government would discharge 25 percent of the original balance of the federal student loan after the student borrower made 36 full-time payments on a 10-year loan and 60 full-time payments on a 20-year loan.

The alternative approach levels the incentives for rapid repayment of student debt and saving for retirement. Students who delay making full payments on their student loan would also delay receipt of the partial discharge on the student loan.  

The more rapid repayment of student loans and the partial discharge of the student loan frees up monthly payments and allows student borrowers to increase savings for other objectives including saving for retirement and a home purchase.

The alternative proposal would benefit all student borrowers including borrowers working at firms that do not have a 401(k) plan, borrowers with at firms with 401(K) plans that do not have employer matches and workers ineligible for their firm-sponsored retirement plan.

The alternative proposal does not favor high-fee 401(k) plans over low-fee IRAs.

The alternative plan does not encourage workers to stay at a job where they might be unproductive and unhappy to claim matching funds.

The partial discharge on student debt reduces demand for Income Based Replacement IBR loans and Public Service Forgiveness Loans (PSFL), both costly programs for taxpayers.

Concluding Remarks:  Wall Street and financial advisors consistently advise their clients to prioritize 401(k) contributions over rapid repayment of student debt.  This approach is not leading to a secure financial life for many student borrowers who are paying more on student debt over their lifetime, incurring high borrowing costs on other loans, having trouble qualifying for a mortgage and raiding their 401(k) plan prior to retirement.   A quick partial discharge of student debt would allow highly leveraged students to increase saving for retirement.

Student Debt Proposal #3: Facilitating on-time graduation

Policies that improve on-time graduation rates outlined here will substantially reduce lifetime student debt burdens.

Background:  

Most of the focus of the discussion on student debt burdens is on proposals to make college debt free and proposals to forgive student debt.  The previous work on student debt published by this blog looked at the possibility of eliminating student debt for first-year students and potential modifications to student loan contracts that would offer limited debt relief. 

The discussion in this post examines whether student debt burdens could be improved through improvements in on-time graduation rates.

This CNBC article states that only around 41 percent of undergraduate students graduate within four years and 59 percent of undergraduate students graduate within six years.  On-time graduation rates are lower for people who start college at a community college and then transfer to a four-year institution.   

People who graduate on time tend to borrow less because of annual limits on student debt.

  • A dependent undergraduate student graduating in four years can take out a maximum of $27,000 in Stafford loans.  
  • The maximum Stafford student debt for dependent undergraduates is $31,000.
  • The overall Stafford debt limit for independent students is $57,500.  People who take longer to graduate are more likely to become independent students and qualify for the higher limit.
  • People who spend a longer amount of time in school may be more likely to take out a private student loan.

A couple of years ago I examined data from NCES on the relationship between amount of time it took for undergraduate to graduate and student debt outcomes for students graduating in 2012. 

  • 73.3 percent of students taking five or more years to graduate incurred debt compared to 62.6% for students who graduated in four or fewer years.
  • Average student debt for students with debt was $31,639 for students taking five or more years to graduate compared to $25,528 for students taking four or fewer years.

These figures understate the impact of duration in school on debt totals because everyone in the sample graduated and the debt totals do not include private loans or PLUS loans.

Improving on-time graduation rates:

Three policy levers designed to improve on-time graduation rates are considered.  The first set of policies involves programs attempting to better prepare students for college.  The second set of policies involves programs and rules impacting students in college.  The third set of policies involves attempts to mitigate the impact of unanticipated events and circumstances, including economic hardships and sexual assault.

Improving preparedness of students prior to college:

Some students are better prepared to succeed in college and graduate on time. The need for remedial courses often increases the amount of time spent in school and the total debt incurred.  

Costs associated with remedial education are not exclusively incurred by low-income or community college students.  One study reveals 45 percent of student taking remedial college work are from middle-income or upper income households and that nearly half are enrolled in four-year public or private colleges.

Several programs are proposed to better prepare students for college including:

  • Efforts to improve early education outcomes: Go here for a study on the importance of early education programs.
  • Efforts to increase access to AP courses and improve AP scores.  The programs discussed heretarget communities with low AP participation rates and attempt to improve both access and performance.
  • Increased access to community college courses while still in high school: The California Dual Enrollment program is an example of a program that allows high school student obtain college credit in high school.
  • Increased early access to camps and courses related to computer programming and coding:  It would be useful to survey people obtaining a CS or STEM degree to more fully evaluate the impact of early access to CS and success in the field.

Polices adopted by colleges:   

Colleges differ substantially in their on-time graduation rate.  Part of the difference is explained competitiveness of the college. Part of the difference is explained by college-specific policies, starting with transparency about on-time graduation rate and other performance metrics.

  • Greater transparency on on-time graduation rates for the university by area of study:  Some information on on-time graduation rates, debt totals, and starting income for universities can be obtained from the College Scorecard.  It would be useful to have more information for schools and for different departments in schools along with an overall rating.   
  • Better monitoring and Increased incentives for students to maintain on-track for on-time graduation:  Some students often enroll in fewer than the 15 credits per semester needed to graduate on time. Go here for a Cal-State article on why students should take 15 hours per semester. A policy requiring students who are behind schedule complete some on-line or summer course work before receipt of additional student loans might be useful.
  • Standardizing AP credit policies:  Some schools and some departments do not give credit for students who pass some AP exams.  Any student who gets a 4 or above on an AP test should get some credit if the institutions is processing federal student loans. The academic issues created by this change could be mitigated by having the department create a new course that overlaps but builds on the AP course. 
  • Reduce loss of credit by transfer students:  This article points out that student lose around 40 percent of their credits by transferring and argues for the acceptance of more transfer credits.  It would also be useful for students to transfer earlier in their career when fewer credits are at stake.
  • Increase access to courses for people needing certain credits for graduation or completion of a major:  Some students fail to graduate on time because they cannot enroll in a course needed for their major or for graduation.  Colleges need to rectify these types of problems and evidence should be reported to the College Scorecard or other Internet sites.
  • Increased Use of on-line courses:  The increases use of on-line courses can be an efficient approach when students are falling behind track for on-time graduation and when students need only a few courses to complete their degree.

Unanticipated Events that could lead to reduce on-time graduation rates:

Economic hardships and sexual assault undermine academic performance and delay the completion of academic programs.

  • On-time graduation would improve if more resources were available to assist students with housing and food.  This study found that economic hardships including lack of stable housing and lack of sufficient food impacts the ability of students to do well in food.
  • On-time graduation would improve if sexual assault was reduced and if resources were used to assist victims.  One study here discusses retaliation by perpetrators and institutional response.  This studyfound evidence that victims of sexual assault were more likely to experience a decrease in GPA and/or quit school. 

Concluding Remarks:  The ability to graduate on-time is a major determinant of the amount of debt a student takes on.  Policies and programs that better prepare people for college, that create incentives for colleges to helps students graduate on time and programs that assist students in difficult circumstances, would improve on-time graduation and reduce lifetime student debt burdens.

Student Debt Proposal #2: Potential modifications to student loans

Proposal considers partial discharge of loans after 4 years and complete elimination of interest charges at or near the maturity date of the loan. Future work will show these proposals are more effective an equitable than existing programs and proposals.


Introduction:

The current cohort of students is entering the workforce with substantially more debt than the previous cohorts of student and the growth of both the number of people with student debt and the average debt level have been consistently upwards. High student debt burdens are leading many student borrowers to forgo saving for retirement, delay starting a family, or put off purchasing a home.  

Some Democrats have urged President Biden to cancel up to $50,000 in student debt for all people with student loans.  Most economists believe that a widespread cancellation of student debt would be an inefficient and regressive subsidy.  Many student borrowers with debt could repay their loan without financial assistance and an indiscriminate loan relief program would allocate resources away from other pressing concerns. Most economic analysis supports the view that indiscriminate student debt cancellation programs would do very little to stimulate the economy.

Several papers including one by the New America Foundation one discussed in Inside Higher Education and my own work published by NASFAA have focused on reforming Income Driven Repayment Plans.  Current Income Driven Repayment (IDR) programs offering debt relief and linking debt payments to income have many problems.

  • The programs may incentivize some students to increase the amount they borrow.
  • Some students that commit themselves to an income linked loan may have been better off with a traditional loan.
  • Some student borrowers enrolled in IDR programs struggle to meet other financial priorities despite the benefits of the programs.
  • A large portion of applications for loan discharge have been rejected by the Department of Education as discussed in this CNBC article.

The memo presented here discusses ways to provide meaningful debt relief through modification of standard loan agreements instead of expansion of IDR loans or the creation of indiscriminate loan discharges.

A Proposal:

  • Discharge 40 percent of the initial loan balance after receipt of 60 monthly payments on 10-year loans and 72 monthly payments on 20-year loans.
  • Encourage partial interest payments for people in economic hardship rather than total payment forbearance.
  • Eliminate Interest charges on all loans on the scheduled loan maturity date.
  • Allow and facilitate collection of outstanding student loans after maturity of the loan by the IRs through federal tax returns.

Benefits of the Proposal:

The proposal presented here eliminates many of the uncertainties and problems associated with current programs offering student borrowers debt relief.    It offers students some assistance early in their careers allowing households to save for other priorities.   It does not create an incentive for students to increase the amount they borrow and contains incentives to facilitate quicker repayment of student debt.  The partial discharge of debt and the elimination of interest charges should reduce the number of people entering retirement with outstanding student debt.

  • The current system does not provide any loan forgiveness for 10 or 20 years.  The earlier debt relief in this proposal allows borrowers to pursue other financial objectives and may facilitate refinancing to lower-interest rate loans.
  • Many borrowers are unaware of any problems with their loan for 10 or 20 years when they apply for loan forgiveness.  The revised program will uncover problems with loan forgiveness applications after 60 months of payments for 10-year loans and 72 months of payments for 20-year loans.
  • The current system incentivizes many borrowers to pick the IDR program as soon as they leave school even though this choice can lead to higher lifetime loan payments if circumstances change.   The revised program assists borrowers with standard loans reducing reliance on IDR loans.
  • IDR plans create an incentive for some people to borrow more than they otherwise would because they anticipate low life-time loan payments and complete loan forgiveness. The alternative loan forgiveness terms presented here will always result in higher repayments for people who borrow more.
  • The loan discharge offered in this program occurs earlier for people making all payments on time, creating an incentive for student borrowers to prioritize student loan payments early in their career.
  • The existence of financial assistance for student borrowers with 10-year loans will reduce an incentive for borrowers to take out long-term loans and will speed repayment to the Treasury.
  • One study found the number of American over 60 with outstanding student debt quadrupled between 2005 and 2015. The elimination of interest charges at loan maturity proposed here should reverse this trend.
  • The elimination of all interest at the loan maturity creates an incentive for borrowers to allocate payments to other debts charging interest.  This problem is mitigated by requiring a minimum payment on student debt outstanding after the loan matures collected by the IRS through the federal tax return.

Concluding Thoughts:

Student debt is creating financial hardships for many borrowers and existing IDR programs often fail to provide meaningful debt relief.  Problems associated with student debt will worsen because of the growth of debt.  Most student borrowers can repay and manage their student debt with limited financial assistance.  An indiscriminate large discharge of student debt would impose costs on taxpayers and divert funds from other pressing priorities.

The program outlined here provides limited quick and efficient debt relief to student borrowers without the distortions caused by existing programs or proposed large-scale debt discharge proposals.

Student Debt Policy Proposal #1: Eliminate or substantially reduce first-year student debt

The elimination of student loans during the first year of college would lower total student debt incurred by most borrowers and provide the largest benefits to people most likely to default.

Potential Policy Changes:  The proposals outlined here involve restrictions on student debt for first-year students, increased financial assistance for first-year students, and new programs to expand access to higher education prior to college.

Specific Proposed Policy Changes:

  • Design and provide funding and incentives for creation of financial assistance packages leading to a debt-free or tuition-free first year at both community colleges and four-year institutions.
  • Eliminate federal student loans until students have 9 credit hours of college credit from AP courses, community colleges or accredited on-line programs.
  • Provide federal, state, and private funds for programs that increase college-level work prior to college.
  • Increased incentives for quick transfers from community colleges to four-year institutions.

Comments:

  • Students who take out loans and do not complete college are around 3 times more likely to default on their loan than student borrowers who get a degree.   The reduction of first-year debt will reduce the debt burdens of people who leave school early and are most likely to experience payment problems.
  • The stipulation that people complete some college level courses prior to full-time college will reduce initial access to higher education by low-income and minority students.  However, these groups with higher student debt burdens would gain the most reduction of first-year debt.
  • The stipulation for some college level experience prior to full-time college would better prepare people for college and would reduce dropout rates.
  • The elimination or reduction in debt among people who leave college after a year or two could facilitate reentry to college after people get some job experience.
  • Low-income and minority students also stand to benefit the most from new programs that increase access to and use of higher education courses prior to full-time college.  For some students, access to a community college or high-quality on-line course would be preferable to access to an AP course with a high fail rate.
  • Universities would be encouraged to increase off-semester admissions to facilitate the admission of more students after a single semester at a community college.
  • The proposed increase in financial assistance at both four-year and two-year institutions will allow more qualified students to choose a four-year alternative.  By contrast, the Biden Administration free-community college proposal would encourage some qualified applicants to delay or forego four-year options.
  • Private schools and historically black colleges could also benefit from changes in financial assistance packages depending in part on the incentives tied to use of federal funds.
  • The changes in financial assistance programs could differ across institutions depending on the level of tuition and the level of state or private support.

Concluding Remarks:  Many people are unprepared for full time college and the burdens of student debt immediately after graduating college.   The proposals outlined here would help many young adults become better prepared for higher education before taking on any debt. 

Financial Tip #2: Prioritize debt reduction over saving for retirement

Tip #2: New entrants to the workforce, facing unprecedented levels of student debt, should prioritize debt reduction over saving for retirement.

Most students with substantial student debt should reduce or forego retirement savings until their debt levels become manageable.  Students entering the workforce with substantial debt could reasonably forego saving for retirement for the first three years of their career. Potential advantages of pursuing a debt reduction strategy and the creation of an emergency fund over saving for retirement include:

  • Reduced lifetime student loan interest payments
  • Improved credit rating and reduced lifetime borrowing costs
  • Reduced likelihood of raiding retirement plan and incurring penalties and tax
  • Increased house equity and reduced stress associated with debt

Discussion of advantages of rapid student loan reduction at the expense of saving for retirement:

  • The decision to initially forego saving for retirement and earmark all available funds towards repayment of student debt leads to a substantial reduction in lifetime payments on student debt.  Two examples of the magnitude of the reduction in lifetime student loan payments are presented below.
  • A student borrower starting her career with $30,000 in undergraduate loans could take out a 20-year student loan leading to a monthly payment of $198.82 and lifetime loan payments of $47,716.   Alternatively, this student borrower could forego contributions to her 401(k) plan, increase student loan payments by $565.4 per month and pay off her student loan in 61 months.   The new total student loan repayments are $33,837, a total savings of $13,879. 
  • A second borrower with three student loans — a $35,000 undergraduate loan at 5.05%, a $40,000 graduate loan at 6.66% and a $25,000 private student loan at 10.00% — choosing the standard 20-year maturity on all loans has a monthly payment of $775 and realizes total lifetime payments of $200,633. The modification of the private loan to a five-year term initially increases the monthly student loan to $1,065.  The total lifetime student loan debt payments for the person who repaid her private student loan in 5 years instead of 20 years and earmarks the reduced loan payment to further loan reduction is $146,271.  This is a total lifetime savings of $54,362. 
  • The student borrower who rapidly reduces or eliminates all student debt can increase savings for retirement once the monthly student debt payment falls or is eliminated. Furthermore, the rapid elimination of the high-interest-rate private student loan could facilitate refinancing of the remaining student debt at favorable terms.
  • The failure to maintain a good credit rating will lead to higher borrowing costs on all consumer loans and on mortgages in addition to higher lifetime student loan payments.  
  • Assumptions on the impact of credit quality on interest rates were obtained for credit cards from WalletHub, for car loans from  Nerd Wallet, for private student loans from Investopedia, and for mortgages from CNBC.  The differential between interest rates on people with good and bad were 9.8 points for credit card debt, 7.0 points car loans, 10.0 points for private student loans, and 1.6 points for mortgage debt.  The monthly cost of bad credit depends on the interest rate differential, the likely loan amount, and the maturity of the loan. The analysis presented here assumes a likely loan balance of $10,000 for credit cards, $15,000 for a car loan, $20,000 for a private student loan, and $300,000 for a mortgage.  The analysis also assumes the borrower only paid interest on credit card debt and loan maturities were 60 months for car loans, 240 months for private student loans, and 360 months for mortgages.  Based on these assumptions, the monthly cost of bad credit was $82 for credit cards, $49 for car loans, $124 for private student loans, and $277 for mortgages.
  • A person who fails to eliminate debt could end up with higher borrowing costs for their entire lifetime.
  • Increasingly, young adults are tapping 401(k) funds prior to retirement to meet current needs.  Often individuals who raid their 401(k) plan prior to retirement incur additional income tax and financial penalties.  A CNBC article reveals that nearly 60 percent of young workers have taken funds out of their 401(k) plan. A study by the Employment Benefit Research Institute (EBRI) reveals that 40 percent of terminated participants elect to prematurely withdraw 15 percent of plan assets. A poll of the Boston Research Group found 22 percent of people leaving their job cashed out their 401(k) plan intending to spend the funds.  New entrants to the workforce who prioritize the reduction of student debt over saving for retirement will be less like to raid their retirement plan and incur tax and financial penalties. 
  • Note from Tip #3 that people using Roth IRAs or Roth 401(k) plans are less likely to pay penalties and taxes on disbursements on retirement savings because the initial contribution to a Roth can be disbursed without penalty or tax.  People with debt should start saving for retirement through relatively small contributions to Roth accounts rather than large contributions to traditional plans.
  • Many people who fail to prioritize debt payments struggle with debt burdens for a lifetime and fail to realize a secure financial future. A CNBC portrayal of the financial status of millennials found many adults near the age of 40 were highly leveraged struggling to pay down student debt, using innovative ways to obtain a down payment on a home and barely able to meet monthly mortgage payments.  A 2019 Congressional Research Service Report found the percent of elderly with debt rose from 38% in 1989 to 61% in 2021.   The Urban Institute reported the percent of people 65 and over with a mortgage rose from 21% in 1989 to 41% in 2019.  A 2017 report by the Consumer Finance Protection Board found that the number of seniors with student debt increased from 700,000 to 2.8 million over the decade.  Many of these problems and financial stresses could have been avoided if the student borrower entering the workforce had initially focused on debt reduction and the creation of an emergency fund rather than saving for retirement.

These problems will worsen if borrowers don’t start focusing on debt reduction over saving for retirement because many in the new cohort of borrowers are starting their careers with higher debt levels.

Concluding Thoughts:  Many financial advisors stress saving for retirement over debt reduction.  Fidelity, a leading investment firm, says young adults should attempt to have 401(k) wealth equal to their annual income at age 30.  Workers without debt and with adequate liquidity for job-related expenses can and should contribute.   Their returns will compound overtime and they will have a head start on retirement.

The Fidelity savings objective is unrealistic for most student borrowers with debt. The current cohort of people entering the workforce has more debt than any previous cohort.  Average student debt for college graduates in 2019 was 26 percent higher in 2019 than 2009.  The decision by a new worker with student debt to go full speed ahead on retirement savings instead of creating an emergency fund and rapidly retire student debt can and often does lead to disaster.  The young adult choosing retirement saving over debt reduction pays more on debt servicing, invariably falls behind on other bills, pays higher costs on all future loans, and often raids their retirement plan paying taxes and penalties.   

Potential Modifications to Student Loans

Introduction:

The current cohort of students is entering the workforce with substantially more debt than the previous cohorts of student and the growth of both the number of people with student debt and the average debt level have been consistently upwards. High student debt burdens are leading many student borrowers to forgo saving for retirement, delay starting a family, or put off purchasing a home.  

Some Democrats have urged President Biden to cancel up to $50,000 in student debt for all people with student loans.  Most economists believe that a widespread cancellation of student debt would be an inefficient and regressive subsidy.  Many student borrowers with debt could repay their loan without financial assistance and an indiscriminate loan relief program would allocate resources away from other pressing concerns. Most economic analysis supports the view that indiscriminate student debt cancellation programs would do very little to stimulate the economy.

Several papers including one by the New America Foundation one discussed in Inside Higher Education and my own work published by NASFAA have focused on reforming Income Driven Repayment Plans.  Current Income Driven Repayment (IDR) programs offering debt relief and linking debt payments to income have many problems.

  • The programs may incentivize some students to increase the amount they borrow.
  • Some students that commit themselves to an income linked loan may have been better off with a traditional loan.
  • Some student borrowers enrolled in IDR programs struggle to meet other financial priorities despite the benefits of the programs.
  • A large portion of applications for loan discharge have been rejected by the Department of Education as discussed in this CNBC article.

The memo presented here discusses ways to provide meaningful debt relief through modification of standard loan agreements instead of expansion of IDR loans or the creation of indiscriminate loan discharges.

A Proposal:

  • Discharge 40 percent of the initial loan balance after receipt of 60 monthly payments on 10-year loans and 72 monthly payments on 20-year loans.
  • Encourage partial interest payments for people in economic hardship rather than total payment forbearance.
  • Eliminate Interest charges on all loans on the scheduled loan maturity date.
  • Allow and facilitate collection of outstanding student loans after maturity of the loan by the IRs through federal tax returns.

Benefits of the Proposal:

The proposal presented here eliminates many of the uncertainties and problems associated with current programs offering student borrowers debt relief.    It offers students some assistance early in their careers allowing households to save for other priorities.   It does not create an incentive for students to increase the amount they borrow and contains incentives to facilitate quicker repayment of student debt.  The partial discharge of debt and the elimination of interest charges should reduce the number of people entering retirement with outstanding student debt.

  • The current system does not provide any loan forgiveness for 10 or 20 years.  The earlier debt relief in this proposal allows borrowers to pursue other financial objectives and may facilitate refinancing to lower-interest rate loans.
  • Many borrowers are unaware of any problems with their loan for 10 or 20 years when they apply for loan forgiveness.  The revised program will uncover problems with loan forgiveness applications after 60 months of payments for 10-year loans and 72 months of payments for 20-year loans.
  • The current system incentivizes many borrowers to pick the IDR program as soon as they leave school even though this choice can lead to higher lifetime loan payments if circumstances change.   The revised program assists borrowers with standard loans reducing reliance on IDR loans.
  • IDR plans create an incentive for some people to borrow more than they otherwise would because they anticipate low life-time loan payments and complete loan forgiveness. The alternative loan forgiveness terms presented here will always result in higher repayments for people who borrow more.
  • The loan discharge offered in this program occurs earlier for people making all payments on time, creating an incentive for student borrowers to prioritize student loan payments early in their career.
  • The existence of financial assistance for student borrowers with 10-year loans will reduce an incentive for borrowers to take out long-term loans and will speed repayment to the Treasury.
  • One study found the number of American over 60 with outstanding student debt quadrupled between 2005 and 2015. The elimination of interest charges at loan maturity proposed here should reverse this trend.
  • The elimination of all interest at the loan maturity creates an incentive for borrowers to allocate payments to other debts charging interest.  This problem is mitigated by requiring a minimum payment on student debt outstanding after the loan matures collected by the IRS through the federal tax return.

Concluding Thoughts:

Student debt is creating financial hardships for many borrowers and existing IDR programs often fail to provide meaningful debt relief.  Problems associated with student debt will worsen because of the growth of debt.  Most student borrowers can repay and manage their student debt with limited financial assistance.  An indiscriminate large discharge of student debt would impose costs on taxpayers and divert funds from other pressing priorities.

The program outlined here provides limited quick and efficient debt relief to student borrowers without the distortions caused by existing programs or proposed large-scale debt discharge proposals.