Last week, the New America Foundation released the policy paper Safety Net or Windfall?: Examining Changes to Income-Based Repayment for Federal Student Loans, which demonstrates that the Obama Administration’s pending changes to the Income-Based Repayment plan for federal student loans, called Pay As You Earn (PAYE), will provide windfall benefits to high-debt, high-income borrowers and could allow graduate and professional schools to raise tuition with impunity. The report also recommends that the Obama Administration make a few tweaks to its proposed changes to IBR before the regulations become final in the coming weeks.
If the Administration allows the pending regulations to take effect without addressing the benefits that the plan will provide for high-debt borrowers, it could jeopardize the integrity of the IBR plan. Even though the IBR plan provides important benefits to struggling, lower-income borrowers, the media and the public may come to view the entire IBR as just another way that government programs are rigged to help the most well-off rather than the most needy.
Below are the common-sense recommendations from the recently-released New America Foundation paper. The Obama Administration should adopt these recommendations as an easy way to fix the windfall benefits and perverse incentives in the pending IBR regulations.
Recommendation #1: Maintain the lower payment calculation (10 percent of AGI) in New IBR, but only for borrowers with AGIs at or below 300 percent of the federal poverty guidelines ($33,510 for a household size of one). Borrowers with AGIs above 300 percent will pay according to the Old IBR formula (15 percent of AGI).
Justification: This change targets the benefits of lower monthly payments under New IBR to lower-income borrowers only. Borrowers earning more, while still eligible for IBR, must make payments based on the Old IBR formula. While the savings that New IBR provides to lower-income borrowers are less than they are for higher-income borrowers, this recommendation would still allow borrowers who are the most likely to struggle to make payments with the added relief offered by New IBR. Additionally, by requiring borrowers with incomes above 300 percent of the federal poverty guidelines to make monthly payments based on 15 percent of their AGIs, it is much less likely that high-income borrowers will receive loan forgiveness. It also allows borrowers with lower incomes to benefit from the 10 percent rate that New IBR offers, but ensures that they will repay those benefits by paying at a higher rate if their incomes increase later.
Lastly, those borrowers with AGIs above 300 percent of the poverty guidelines will likely have total incomes that are markedly higher than their AGIs because they are able to make pre-tax benefit payments, contribute to retirement savings, and take larger above-the-line deductions. Imposing a higher payment calculation (15 percent of AGI) on these borrowers compensates for their significantly lower AGIs relative to their total salaries.
Recommendation #2: Maintain the loan forgiveness threshold from New IBR (20 years), but only for borrowers whose loan balances when they entered repayment do not exceed $40,000. Borrowers with higher initial balances would qualify for loan forgiveness after 25 years of repayment, the same as under Old IBR.
Justification: Like the first recommendation, this proposal would maintain the more generous benefits of New IBR, but not for all borrowers. A two-tiered loan forgiveness system based on initial debt levels would keep the 20-year loan forgiveness targeted toward borrowers who have debt from undergraduate studies or moderate amounts of debt from graduate studies and who struggle to repay. By creating a longer loan forgiveness threshold for borrowers with debt levels above $40,000, this recommendation also reduces the tendency that New IBR has to provide loan forgiveness to high-income, high-debt borrowers when they are most able to make higher payments on their loans for a total of 25 years. This two-tiered approach would discourage graduate and professional schools that charge high tuitions and their students who borrow federal loans from using IBR as an indemnification tool.
Recommendation #3: Eliminate the maximum payment cap. Borrowers must always pay based on the IBR income formulas, no matter how high their incomes are. Additionally, borrowers may not opt to enroll in another repayment plan once enrolled in IBR.*
Justification: The maximum payment cap targets IBR benefits to higher-income borrowers either by reducing their monthly payments, increasing the amount of loan forgiveness they receive, or both. It can also increase the chances that a borrower earning a very high income (over $200,000) would qualify for loan forgiveness. Lastly, requiring that borrowers stay in IBR for the duration of their repayment term once they enroll will ensure that borrowers who used IBR when their incomes were low will pay commensurately higher payments should their incomes increase—this helps offset some of the initial costs the government incurred when the borrowers benefitted from low payments while their incomes were lower.
Recommendation #4: The U.S. Department of Education and policymakers should be forthcoming about the negative consequences borrowers may face when repaying through IBR. The Department should promote the consolidation repayment option as another alternative that borrowers have to reduce their monthly payments and extend their repayment terms, particularly given how similar IBR is to the consolidation repayment plans for many types of borrowers. The Department should provide borrowers with illustrative examples of how paying off their loans more slowly could increase what they pay and provide clear warnings. Private companies servicing federal student loans should clearly indicate to borrowers how much interest accrues on their loans when they repay through IBR and how that is likely to increase the repayment term and total interest costs they will pay. Policymakers should also make consolidation less onerous for borrowers; currently, it requires significant paperwork and effort to enroll.
Justification: Some policymakers and student aid advocates have promoted IBR with hardly a mention of the financial risks it poses for borrowers (those risks exist for Old IBR, the only plan in which borrowers have enrolled to date, though New IBR entails far less financial risk for borrowers with debt levels that exceed $20,000). Borrowers may save little per month under IBR and end up paying more and for longer due to the added interest costs. Borrowers do make a trade-off in choosing IBR over other repayment options, and loan servicers and the U.S. Department of Education should ensure that borrowers are informed of those trade-offs.
Recommendation #5: IBR payments for a borrower who is married but files a separate income tax return should be based on the household’s combined AGI. The program currently allows borrowers to file separate income tax returns and use only the borrower’s income to calculate payments under IBR. This policy should include an exception for cases where both spouses are making payments on federal student loans under IBR. In that case, each borrower’s loan payments should be based on one-half of household income.
Justification: Married borrowers with low individual, but high household incomes can still qualify for IBR (including loan forgiveness) by filing a separate income tax return. If these borrowers also have children, they can significantly increase the benefits they earn under IBR by claiming the children as dependents on their own federal income tax returns since it increases their household size and the poverty exemption they receive under IBR.** This provision is another way in which higher-income borrowers (based on household income) can qualify for generous benefits under IBR. Ending this provision will ensure that the program’s benefits are targeted to borrowers who need the most assistance. The exception for couples in which each spouse is repaying a federal student loan will ensure that borrowers in a two-borrower household do not each have to make payments on their loans on their combined incomes—which would essentially be double-counting their incomes.
Recommendation #6: Make loan forgiveness tax-free using budgetary savings that arise from the other recommendations outlined above.
Justification: Federal tax law treats loan forgiveness under IBR (except when provided for public service employees) as taxable income. Borrowers who receive loan forgiveness (under an IBR that reflects the recommendations outlined here) will likely have experienced some degree of financial hardship. Therefore, they are also likely to struggle with what could be a relatively large tax bill in the year they receive loan forgiveness. If IBR is meant to aid this type of borrower, then it should not impose its own type of financial burden on them.
Recommendation #7: Allow all borrowers to enroll in an IBR that reflects these recommendations. Do not limit it to new borrowers. Use the savings that would arise if policymakers implemented all of the recommendations listed above to offset the incremental costs of this recommendation.
Justification: Old IBR is available to all borrowers, but Congress and the Obama administration have limited access to New IBR to more recent borrowers to reduce the cost of the program. The recommendations outlined above would preserve some of the benefits of New IBR, but target them to those borrowers with more financial need, thereby reducing the cost. The recommendations would further reduce costs by limiting benefits to higher-income borrowers compared to even Old IBR. Therefore, policymakers could open the program to all borrowers at little or no incremental cost to taxpayers, and a greater number of borrowers would gain access to lower repayments and earlier loan forgiveness.
*The recommended IBR would capitalize a borrower’s accrued unpaid interest once his payments under IBR exceed what he would be required to pay under the standard 10-year repayment plan based on his original loan balance. This is consistent with the practice currently under both Old and New IBR.
**Note that a borrower repaying through IBR need not claim a child as a dependent on his or her tax return in order to have the child included in his or her household size under the IBR payment calculation. The borrower must simply designate the child as a dependent on the IBR application annually, regardless of who claims the child as dependent for purposes of federal income taxes. The New America Foundation paper incorrectly asserts that the two are one in the same when they are not. This error does not affect our findings. We regret the error.