The Brainless 'No-Brainer' Fix to the Student Loan Problem

You know what they say about opinions, right? Well, the same can be said about so-called no-brainer fixes to the student loan problem, as a recent Bloomberg.com article illustrates.

This particular “fix” has to do with the 57% of federal student loan borrowers who were drop-kicked out of the government’s various income-based repayment (IBR) plans in 2015 because they failed to file their income-verification paperwork on time.

According to the Obama Administration and the departments of Treasury and Education (and that post on Bloomberg.com), the process needs streamlining. How? By permitting borrowers to authorize the Internal Revenue Service to share their tax return data with the private-sector companies that administer their government-backed student loans.

Hang on…

Aren’t we talking about the same administrators that the government had called out for loan-servicing malfeasance?

Hmmm.

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And what about requalification as a concept? Why is there even such a thing when loan restructures—which is what we’re talking about here because interest rates and principal balances remain unchanged—are typically a once-and-done affair?

Yes, I know that income-based repayment is income specific. But if we are to take the ED at its word when it says that IBR is the key to achieving a “zero default rate among student loan borrowers,” and if this type of relief plan accomplishes this by extending repayment terms to as long as 20 years’ time — twice the duration of the standard student loan agreement — wouldn’t doubling the remaining term of any student loan yield the same result?

According to the Federal Reserve Bank of New York’s August 2016 report on consumer credit, 11.1% of all student loans are 90 or more days past due. Well, since roughly half of all these loans are actually in repayment (the balance is deferred because the borrowers are still in school), that means that more than 20% of the loans that are “live” are, technically speaking, in default.

Technically, because that’s the way all of the lenders I know treat all other consumer and commercial financings that are three or more payments in arrears.

Add to that, the loans that are between 30 and 90 days past due — because these may well portend future defaults — along with those that are being temporarily accommodated with forbearances (not to mention the loans that have already been granted conditional relief under the various income-based plans) and it’s not hard to see how nearly half of all loans that are currently in repayment are distressed.

A portfolio that is so clearly troubled is one that was improperly structured at the outset. So, if you’re seeking a true no-brainer fix, refinance the whole damn thing.

And not at the rates that are currently being charged, either.

The reason that the government has been reporting multi-billion dollar profits in this sector is because the feds are, in effect, lending long and borrowing short. Back in 2013, Congress devised a plan that charges students for borrowing 10-year money at rates that are roughly commensurate with that duration, only to have the Treasury turn around and fund the ED’s program with significantly less expensive short-term debt.

That the profits from this scheme offset the federal deficit is of course a happy coincidence. And that the government runs the risk of bankrupting its existing portfolio of reduced-rate loans if (and when) short-term rates rise to the point of exceeding those that are implicit within the underlying agreements is also beside the point. Right?

Wrong.

Just as Congress should acknowledge what is painfully obvious about the tenuous condition of these debts and move to refinance all government-backed student loans, so too should it devise an appropriate rate to charge.

It can start by acting like it knows what it’s doing.

Interest rates are built from the ground up. The first building block is the lender’s raw cost of borrowing, which, if we’re talking about 20-year loan terms, is the 10-year Treasury note (lenders use the so-called half-life rate for term loans). Add to that the interest rate equivalents of the costs of originating and servicing these contracts, along with a reasonable estimate for losses.

Here’s how the numbers shake out.

At the time of this writing, the 10-year Treasury note yielded 1.8%. Also at the time of this writing, the ED is charging slightly more than a 1% upfront fee for originating undergraduate student loans (a 0.1% interest rate add-on), and loan servicers are typically paid 1% for administering contracts of this type (another 0.1% interest rate add-on). As for the losses, let’s say that the government is wrong about zero defaults and put that number at 10%—higher than for any other form of consumer debt. The interest rate equivalent of that is 1.0%. Add up the pieces and you get 3.0%.

Wait a minute…

That means that the 3.76% rate that Congress concocted for the ED to charge at this time for its 10-year Federal Direct loans is overpriced by a whopping 25%. And that’s without taking into effect the fact that the pricing basis for 10-year loans should have been the 5-year Treasury note, which costs about a half a point less than the 10-year instrument.

All the more reason to reject this no-brainer fix and do what truly needs to be done: Permanently modify the contracts that are currently in place and adjust the existing program’s terms to match.

And one more thing.

Let’s not punish the roughly 50% of borrowers who are not having difficulty making their payments by forcing them to incur higher aggregate interest costs over the newly extended term. Instead, pave the way for them to continue paying what they’ve been paying by mandating that loan servicers automatically credit all supplemental remittances against principal (when no other payment-related obligations such as late fees are outstanding), rather than against future payments as is often the case.

Just because a borrower may neglect to specify his intent, or fail to realize that paying ahead on a loan is akin to remitting interest that has yet to be earned, shouldn’t mean that the lender or its subcontracted loan administrator is entitled to selfish advantage.

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

Image: Jacob Ammentorp Lund