It’s the start of another new year — a time for reflection, resolutions and W-4 filings.
What if — along with the federal, state, local, Social Security and Medicare taxes that are automatically withheld from every payroll check — student-loan borrowers could also have their payments extracted from that as well?
That’s precisely what the New America Foundation, Young Invincibles and the National Association of Student Financial Aid Administrators are proposing in their recently published, thought-provoking report: The Case for Payroll Withholding — Preventing Student Loan Defaults with Automatic Income-Based Repayment.
As the report’s subtitle suggests, the authors are attempting to tackle the twin issues of student-loan payment delinquencies and defaults — which occur with greater frequency and in greater numbers than for any other form of consumer borrowing — with an innovative twist on the oft-proposed solution of income-based repayment: Loan payments would be calculated on and withheld from a borrower’s current paycheck.
The idea makes a lot of sense.
As the authors rightly point out, the present system is documentation-intensive (tax returns or other forms of income verification), repetitive (annually updated applications), manual (borrowers must remit their payments) and dated (calculations are based upon prior-year earnings). Consequently, whatever relief that is ultimately approved may not correspond with the borrower’s current financial circumstances.
Yet, as well-intentioned as this idea may be, it still doesn’t fully solve the problem.
For instance, take borrowers who are self-employed with sporadic earnings. How would their monthly payments be calculated and by whom? What about food servers who are often paid low-level salaries because of tips they may receive? And what about the employers? To what extent would a program that’s uncomfortably analogous to wage garnishment come with added fiduciary responsibilities?
If anything, the fact that there is so great a need for income-based repayment plans — more than half of all borrowers whose loans are in repayment are unable to comply with the original terms of their financing agreements — should make plain the fundamental problem that underlies this contentious issue: Education loans are improperly structured from the get-go.
Given the magnitude of average student borrowing (public and private education-related debts, including from the use of credit cards) versus the relatively low level of earnings during the first several years of post-college life, it’s no wonder that so many borrowers are struggling to meet the payment demands of the standard 10-year loan.
So instead of complicating matters with onesy-twosy, income-based repayment calculations that could very well result in term extensions to as long as 20 years, why not embrace the inevitable, bite the bullet and restructure the entire portfolio of student loans for a comparable duration to produce, roughly, the same result?
Creating a Manageable Loan
There are, however, two matters that require front-end attention.
Longer-term loans are always more costly for borrowers because principal amortization is slowed, and more interest is paid over time. That’s why it would be important for them to be contractually entitled to accelerate the repayment of their debts — in full or in part — at any time and without penalty. Doing so would accomplish three things: Borrowers would have the ability to limit their overall cost; the contractual prepayment provision would protect them against conflicting policies or practices (should the loans be sold to or serviced by others at a later date); and borrowers would have the luxury of falling back on the originally agreed-to lower payments should they encounter financial difficulties in the future.
As for the second matter, since we’re talking about the wholesale restructure of the entire student-loan portfolio, why not also address once and for all the manner in which interest rates are set?
Let’s start with the way the government funds its student loan program.
The reason the U.S. Department of Education’s earnings from this activity are so high is because the government is, in effect, “borrowing short and lending long.” In plain English, it’s funding higher-rate 10-year loans with lower-rate three-month money. As those of us who’ve lived on the lending side of the financial-services industry know from experience, the proper — and because interest rates can only go up at this point, less risky — way to finance these fixed-rate loans is with fixed-rate borrowings for terms that are roughly half the underlying loans’ duration.
Add to that truer funding cost a more precise value of the administrative expenses, the Education Department actually incurs to manage the loans it makes, and borrowers would be charged a fairer price than they are today.
Wider access to income-based repayment plans is a good idea for all the right reasons. But extending repayment terms, rationalizing interest rates and funding the program in a way that ensures its longer-term viability is a better one, that is if the goal is to serve more people with less hassle.
This story is an Op/Ed contribution to Credit.com and does not necessarily represent the views of the company or its affiliates.
More on Student Loans:
- A Credit Guide for College Graduates
- How to Pay for College Without Building a Mountain of Debt
- Strategies for Paying Off Student Loan Debt