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The New Economics of Student Debt
The consequences will be large
Last summer the Supreme Court of the United States struck down the Biden Administration’s student loan forgiveness plan. I discussed the plan in detail here in February. At the time, I thought the plan had a bit of a Trojan horse aspect to it. The $10,000 forgiveness to students was getting the lion’s share of the media attention even though that was only one part of the plan. The other parts of the plan would also cause large changes to the existing student loan structure. Because the HEORES act allows the Department of Education to “waive or modify” loan rules, the Biden administration is free to alter the terms of loans, even if it cannot cancel them. Those alterations have the potential to completely change how higher education is financed.
These loan modifications have been rebranded as the SAVE plan, and details of the plan can be found here. The SAVE plan is an income-based repayment plan, meaning that money owed is determined not by how much the borrower spent, but by how much the borrower makes after graduation. This is common enough, and income-based repayment plans aren’t necessarily a bad idea. It creates a system in which those with high incomes subsidize those with low incomes, regardless of how much those students spent on their degrees. Someone who takes out $50,000 worth of debt and makes $150,000 a year will pay back more than someone who took out $80,000 worth of debt but only makes $40,000 a year. One can argue before or against such a system, but it does have merits.
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The changes the SAVE plan brings to student debt is how money owed is calculated. Under the current REPAYE plan, borrowers pay 10 percent of their discretionary income, where discretionary income is defined as any income above 150 percent of the federal poverty line. For a borrower who is a single adult with no dependents, the federal poverty line is $14,580, while 150% of the poverty line is $21,870. So under the REPAYE plan, a borrower that makes $50,000 a year has to pay 10 percent of the money earned above $21,870. That means they make payments of $50,000-$21,870=$28,130. In this case 10 percent of $28,130 is equal to $2,813 a year, or roughly $235/month.
The SAVE plan alters these terms significantly. Instead of paying 10 percent on income over 150 percent of the poverty line, beginning next summer borrowers will pay 5 percent on income over 225 percent of the poverty line. For our borrower who makes $50,000 a year, that’s a huge difference. Instead of paying $235/month, under the SAVE plan the borrower would pay roughly $72/month. This implies almost $2,000 in savings per year.
The SAVE plan also completely changes how interest is calculated. As long as borrowers pay their balances, their balance will not grow. This is far different than the current plans, where borrowers making small payments often saw their balance grow over the years. To give a numerical example, let’s take a one-person household that has $100,000 in debt and makes $60,000 a year. Let’s also say that their loan has a five percent interest rate. Thus, their calculated payment would be $1,360 a year. Since the interest accrued is $5,000, the $1,360 paid goes entirely towards interest. The remaining $3,640 of interest is forgiven, and at the end of the year, the borrower’s balance stays at $100,000 owed. Finally, after 20 years of making payments, any remaining balance from undergraduate loans is forgiven under the SAVE plan. Graduate loans require 25 years of payments.
So why is this such a big deal? Because it completely changes the incentives of repayment. First, because the repayment amounts are so low, very few individuals will ever pay off their debt. Consider the example of a single tax filer who has $100,000 in undergraduate and graduate debt and makes $60,000 a year. That individual will never pay off even a penny of the principal owed. As shown above, each year they will pay $1,360 a year and 100 percent of that goes towards interest. Since the interest is more than $1,360 a year, the balance never changes. After 25 years of paying $1,360 a year the $100,000 balance is then forgiven. A borrower with $100,000 in debt would have to make $133,000 to even start paying off the principal. Even then, only a few dollars per year would go towards the original balance. After 25 years their balance is still roughly $99,550. Obviously in the real world that borrower would not have a constant income of $133,000 and would likely be part of a larger household, but the point remains: the vast majority of borrowers under this program will never make a real dent in their balances. Taking just 5 percent of income earned over $32,800 ensures that.
Of course a lot of borrowers will not be making $133,000 a year. That high of income would put an individual in the top 10 percent of all workers. Most college graduates will make less than that for the majority of their 25 years of repayments, and some will never reach it. This creates some odd results. Any borrower with $100,000 in debt who never makes $133,000 in a year will have the $100,000 remaining balance after 25 years. Doesn’t matter if their income is $40,000 or $110,000. The incentives are clear. For those planning to pursue graduate education, the best financial option for many will be to take a maximum amount of loans out per year. Plan on making payments for 25 years after graduation, and then get the rest forgiven. The only rule keeping tuition from exploding is the current federal maximum loan amounts, which are $57,500 for undergraduate students and $138,500 for graduate students. Even these are not ironclad, as graduate students can also take out PLUS loans.
For those who plan on only getting a bachelor’s degree, the best option for many families may also be to pay as little upfront as possible. The student can max out their loans, pay 5 percent of their discretionary income for 20 years, and then have the rest forgiven. That does not in any way incentivize universities to keep tuition low or students to minimize costs.
The one catch to all this is that the balance forgiven after 20/25 years is, in most cases, taxable. So our borrower with a $100,000 balance would have to pay federal and possibly state income tax on the $100,000 forgiveness. However, there are doubts that this will happen. Currently, all student loan forgiveness is not considered taxable income at the federal level due to the American Rescue Plan Act of 2021. This is supposed to expire at the end of 2025, but if Biden is elected to a second term I expect it to be extended. Otherwise there will be stories in the media of people who have paid back their student loans for 20 years now being hit with a $10,000 tax bill. Considering that the entire program is an obvious vote-buying tactic, it’s highly unlikely student debtors are going to see a massive increase in payments while Biden is in the White House.
Especially for the graduate degrees, the SAVE program represents a sea change in the cost-benefit calculation of students. For those who plan on entering relatively low-paid fields, it will now be financially profitable to maximize federal loan amounts. Students can take out tens of thousands of dollars in excess loans and spend it on nicer housing or other living expenses. After graduation, make small payments for 25 years, and have the remaining balance forgiven. Even in that forgiveness is taxable, borrowing $100,000 today, paying back $2,000 per year for 25 years, and then paying $15,000 in tax is a great bargain. Universities will quickly recognize this as well and will change their prices accordingly. The result, far from being a decrease in the costs of college, will be just a transfer of payment from the student to the federal government. Which may have been the intent the whole time.