Student Loans Need an Overhaul, Not Small Changes

Student loan debt is the elephant in America’s living room, and with good reason. According to the most recent data from the U.S. Census Bureau and the National Center for Education Statistics, the average annual cost of tuition for a four-year school represented more than 40% of median household income in 2010.

That helps to explain why two out of three college students who are graduating with debt are doing so with an average of $25,250 in education loans plus another $4,100 in related credit card debt (per The Project on Student Debt and SLM Corporation, respectively).

Liabilities of this magnitude so early in a student’s life have the potential to diminish the quality of that life by crowding out many of the things we take for granted. Cash-strapped grads are delaying marriage and children, or even moving out of their old bedrooms at home, for that matter. They’re also putting off car and other major purchases, with obvious macro-economic ramifications.

And yet, we’re quibbling over interest rates instead of coming to terms with a problem that requires a great deal more than the plodding, incremental approach being taken by the Federal Student Aid office and congress.

For example, while the government’s Income-Based Repayment Program is a decent starting point for addressing this crisis, it excludes private education loans, those that are already in the IBR Program or in ordinary repayment (for 2011 grads and older), as well as those that are currently in default—arguably the loans that should be addressed before all others.

By contrast, the Student Loan Forgiveness Act of 2012 (H.R. 4170) proposes to include older as well as private loans but, in the case of the private loans, only when total education debt (government and private combined) exceeds average household income for each of the previous three years. Also, it’s unclear whether or not defaulted loans would be eligible for consideration.

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As for the “forgiveness” part, the government program requires 20 years of payments to reach that point as opposed to the 10 under H.R. 4170. The House resolution also ups the ante by proposing to forgive borrowers who’ve already paid in for 10 years.

With all of this in mind—and speaking as a former lender, student loan borrower and a parent of two kids who’ve made their own way through college and grad school—I’d like to suggest an alternate approach that has the potential to address the totality of the problem while distributing the pain a little more evenly. I say that because while I’m convinced that the schools, government and private lenders have all contributed to the making of this grand mess, students and parents are also responsible for their part of it.

I believe that the government’s Income-Based Repayment Program should be expanded to include all loans without preconditions (i.e.; older, restructured, defaulted and private loans). The soon-to-be-implemented modifications to the discretionary income calculation would prevail, resulting in the potential for some level of loan loss on the part of the government and the private lenders, should distressed borrowers remain in the program for its duration.
The bankruptcy laws should be changed as well, to permit the discharge of private education loans. This would give the private lenders the proper incentive not to resist this workout program. It would also level the playing field somewhat—lenders that know that their borrowers have the ability to pull the plug (declare bankruptcy) are well motivated to find solutions, particularly when their loans are under-collateralized or, as it is in the case of education loans, where there is no underlying collateral.
The interest rate for these restructured loans should be no greater than for the subsidized Stafford program (3.4%). After all, this is a workout.
The maximum repayment term should remain at 20 years because anything less would unfairly reward those who borrowed the most.

Going forward, I’d also like to suggest that the government-sponsored loan program be modified as follows:

The Aggregate Loan Limit would be annually reset to a maximum of one times the then-current average salary for college graduates, which the National Association of Colleges and Employers reports as $42,000 for 2012. At today’s 6.8% government rate (Direct Unsubsidized), the monthly payments would equal 14% of that salary when the repayment term is 10 years, 11% when the term is 15 years and 9% when it’s 20 years.
The standard repayment term for all government loans would be set at 20 years. Unsubsidized borrowers should be encouraged (if not required) to pay the interest while they’re in school in order to avoid the compounding effect that would add to their obligation, while diminishing their ability to borrow under the program.
Rates would be indexed to the 10-year Treasury, plus a premium to cover administrative costs. (The 10-year Treasury approximates the cost to fund a 20-year, fully amortizing loan program.)

Consumers requiring additional borrowing may then decide to apply for loans from the private lenders, although with the change in bankruptcy laws that I’m advocating, that’s probably going to be tougher to accomplish. Consequently, I would expect students and their families to become even more frugal with their higher education dollars as they consider alternative school settings, degree acceleration and other cost-saving strategies.

I would also expect these moves to pressure the schools to rethink their cost structures, as they should.

This story is an Op/Ed contribution to Credit.com and does not represent the views of the company or its affiliates.

Image: Mr. T in DC, via Flickr