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Our student-loan system needs fixing — and this change would be smarter than just forgiving debt

Most of the recent discussion of student debt has focused on the prospect of forgiving that debt—telling borrowers that they don’t have to repay the funds the federal government provided to help them pay for college or graduate school.

The fierce debates about the pros and cons of such a policy rarely focus on the advantages of extending credit to students or on what debt forgiveness today would mean for students borrowing tomorrow, next year, and for the foreseeable future.

Should President Biden cancel outstanding student debt, it would not relieve students from reliance on borrowing in the future. Indeed, if student loans are forgiven, some parents may receive cancellation notices for their student loans on the same day their children sign agreements for their own loans.

Read: Here’s how Biden could move to cancel student loans

Most people coming out of high school want, for good reason, to go to college, and most of their parents can’t afford to cover all the costs. Adults returning to school to improve their labor market opportunities rarely have the cash to pay up front. Yet while governments help with grant aid and subsidies to public colleges, as a society we are pretty clearly unwilling to pay taxes at the level needed to pick up the tab for people who can’t afford to pay.

Borrowing to fund an investment with a high expected rate of return is rational. Entrepreneurs with business plans do this every day. And as with higher education today, other significant investments in the story of U.S. economic growth — railroads, chemicals, electricity — have relied on federally provided loan subsidies. Just ask Elon Musk: Tesla was a major beneficiary of government subsidies in its early years. 

Government-supported loans have been a core element of higher education financing in the U.S. since Lyndon Johnson made federal loans central to his effort to remove financial barriers to college education through the Higher Education Act of 1965.

Recognizing the need for an ongoing federal student-loan system puts the design of that system at the forefront. The current system is deeply flawed. It can be strengthened so students continue to have access to this critical funding without facing undue burdens when it comes time to repay.

The following feasible changes would alter our student-loan system so it can improve opportunities for students from all backgrounds.

First, higher education has a high average rate of return, but it does not pay off for everyone. Some students leave school without a credential and never enjoy the earnings boost they hoped for. Some earn credentials that don’t pay off well, either because their chosen professions are low-paying or because they don’t find good jobs

A sound financing plan will reduce the share of borrowers whose investments do not pay off by holding institutions accountable for student outcomes, excluding schools that do not serve students well from eligibility for federal student aid programs. The federal government should move forcefully to implement such restrictions.

But some insurance against poor outcomes is a requirement for a loan system that does not leave personal crises in its wake. For this reason, income-contingent loans (ICL), where monthly payments are limited to an affordable share of borrowers’ incomes, are increasingly popular both in the U.S. and in other countries. ICL programs generally provide that any balance that is unpaid after a certain number of years be forgiven.

In the U.S., we have made piecemeal reforms, with borrowers choosing from a confusing array of repayment plans—some income contingent and some with fixed monthly payments.

In the U.K. and Australia, all borrowers are automatically placed in ICL. Payments are collected through the tax system and adjust immediately when borrowers lose their jobs or experience other significant changes in their earnings.

In the U.S., the one-third of borrowers who have taken the steps to enroll in ICL must provide documentation annually to verify their incomes. Many fall out of the plan because of this requirement. Many still default on their loans—albeit a smaller share than among those in other plans.

Making ICL automatic will remove the private loan servicers with whom the federal government contracts to provide guidance to borrowers and process their payments. This system has been rife with problems of inefficiency and corruption.

Princeton University Press

But the payment structure also needs modification. There are frequent calls for lowering expected payments. Some borrowers’ personal circumstances surely make their payments burdensome, but for most the current 10 % of income exceeding 150% of the poverty level is not onerous.

That said, raising the threshold for beginning payments to 200% of the poverty level would come closer to assessing only earnings exceeding those of typical high-school graduates.

In addition:

Borrowers whose monthly payments do not cover the interest charged see their loan balances increase, even when they are in good standing. Limiting the amount of interest that can accrue would mitigate this problem.

A disproportionate share of the loan forgiveness under ICL is projected to go to those who borrowed for graduate school. Most people eager for larger public subsidies to students do not have these students in mind. While there are strict limits on the amount undergraduate students can borrow from the federal government, this is not the case for graduate students. Imposing such limits would reduce the cost to taxpayers and make the system more equitably targeted toward increasing access to and success in undergraduate education

For borrowers who do not fully repay their debts before balances are forgiven (typically after 20 years for undergraduate borrowers), the amount they repay depends only on their earnings paths, not on the amount they borrowed. This is a giveaway to those with large debts and unfair to those who made the effort to hold their borrowing down. Tying time to forgiveness to amount borrowed could solve this problem.

We have further detailed guidelines for strengthening the ICL system elsewhere. In an environment where mitigating current difficulties with loan repayment is both politically and economically critical, we should keep the basic purpose of student loans, which is to help more people attend and succeed in college, front and center. To achieve that end, we need to do a better job of steering students away from educational options that will serve them poorly while ensuring that students whose education has helped them prosper pay back their loans.

Barring a dramatic transformation of our tax system and the resources available to pay for higher education and to cover students’ expenses while they are in school, eliminating federal student loans would severely restrict educational opportunities in the U.S. Fixing the current system is the best approach to preserving and augmenting those opportunities.

Sandy Baum is a nonresident senior fellow at the Center on Education Data and Policy at the Urban Institute and professor emeritus of economics at Skidmore College in Saratoga Springs, N.Y. Michael McPherson is president emeritus of the Spencer Foundation and Macalester College in Saint Paul, Minn. They are the authors of “Can College Level the Playing Field? Higher Education in an Unequal Society.”

Now read: Teens headed to college this year could face almost $40K in debt, and more parents are shouldering the load

Plus: ‘I was treated unfairly by everyone’: Student-loan lawsuit claims government and collectors cost borrowers tax refunds and Social Security checks

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