At a speech in Columbus, Ohio, on October 13, candidate (now President-elect) Donald Trump announced that his student loan plan would cap repayment at no more than 12.5 percent of the borrower’s income after graduation, and that any amounts remaining after fifteen years would be forgiven.
Some media reports declared that the proposal was surprisingly progressive and more generous than existing options. But whether it is more generous to borrowers depends on details that have not been announced. Here we offer a guide to the decisions that the Trump Administration will need to make in designing a plan for income-driven repayment (IDR) of student loans, along with a timeline (and a more detailed chart for download) describing the design of plans proposed over the past fifty-three years.
Which Income Counts?
All IDR plans involve some consideration of the borrower’s ability to pay, based on “income.” The logic of IDR would only take a portion of the income
gained from the training, but that counterfactual information is not known. The current dominant U.S. IDR plans protect just under $20,000 of an individual’s earnings. Australia’s plan leaves untouched an individual borrower’s income up to nearly $30,000.
Another policy choice involves how to handle a spouse’s income. Early proposals worried about a “negative dowry” problem: men shying away from women who carried a repayment obligation. In any plan that ultimately forgives some debts, failing to consider spousal income means a higher cost associated with non-working spouses with debt.
The incoming Trump administration has not indicated whether any income will be excluded nor how marriage would be treated.
How Is the Payment Determined?
There are three basic approaches to basing payments on incomes: a variable percentage, a fixed percentage, and a payment cap. Under a variable percentage plan, the percentage of income that a borrower pays depends on the amount that is borrowed. A Yale plan from the early 1970s, for example, asked students to pay four-tenths of a percent of their income for every thousand dollars borrowed, so that someone who borrowed $10,000 would pay 4 percent of their income. A fixed percentage plans has borrowers pay the same proportion of income regardless of the amount borrowed, so the amount borrowed affects only the duration of repayment. That is how the newest federal plan,
known as REPAYE, works. The other current federal IDR plans in the United States uses the third approach, a payment cap that prevents payments from exceeding a fixed percentage of income. Under the payment cap approach, there is a payment (such as the standard amount to repay a loan in ten years) that is the amount the borrower pays unless that payment exceeds, say, 10 percent of income. If the standard payment would exceed the percentage cap, then the borrower pays only the capped amount.
Generally either the amount of a payment (standard or percentage) or the duration of payment is higher when the amounts borrowed are higher. If not, there can be unintended consequences, because if schools or students are able to predict that neither the payment size nor the duration of payments will be affected by the amount borrowed, they have little reason to restrain prices or borrowing.
Candidate Trump described his 12.5 percent plan as a “cap,” so it might operate much like the current IBR program, which is based on a standard flat payment with a percentage cap. But it is impossible to know based on the October 13 speech alone.
How Is Interest Handled?
With a traditional mortgage-style loan, interest that is not paid is usually
capitalized. In other words, it is added to the amount owed, with interest in the next period charged on the new higher balance and the required payment increasing accordingly. In versions of IDR that monitor a balance owed, many borrowers will have periods during which their required payment does not cover the interest. Capitalizing interest can be distressing to borrowers (and to policymakers). Waiving the interest, however, is costly to the system, because it reduces the amount that will be recovered from borrowers whose incomes ultimately recover.
In some conceptions of IDR, there is no such thing as interest per se: a percentage of earnings is owed for a certain number of years, and then the borrower is finished whether or not the lender’s original investment was recouped. In such plans, borrowers with high income can end up paying what are, in effect, very high interest rates. The confiscatory nature of the approach can lead to the problem of
adverse selection: students who expect to make a lot of money disproportionately opt out of the whole system, robbing the system of money that was expected to cover for lower-income students that did not fully repay.
To prevent adverse selection, one hybrid approach is to essentially front-load the interest, capping the total amount that borrowers will repay at, say, 75 percent more than the amount borrowed (candidate Jeb Bush
proposed exactly that in January). The effective interest rate in this approach is higher for those with high incomes because they pay faster, and lower for those with low incomes because their payments are stretched out longer (and a portion may ultimately be forgiven).
There are no details yet about how interest would be handled in the Trump plan.
When Do Payments End?
The longer the repayment period, the lower the payment can be and still have the program break even. Most plans end no later than when a borrower has repaid principal plus an interest or inflation charge. Many proposals also promise an end point of a particular number of years, with any balance remaining forgiven at that point. Since the payments are income-driven, forgiveness goes to borrowers with lower incomes during the repayment period relative to the amount borrowed.
Most of the current federal plans in the U.S. forgive remaining debt after twenty years in repayment, or when loan is repaid with interest, whichever occurs first. A separate program, known as
Public Service Loan Forgiveness (PSLF) forgives debts remaining after ten years of work in government or nonprofit jobs.
In the Trump plan, remaining debts would be forgiven after fifteen years. But there is no information provided about whether borrowers who had paid a certain amount of principal and interest would be able to finish repaying earlier than fifteen years, nor whether the current PSLF program would remain in place.
Is the System Meant to Be Self-financing or Externally Subsidized?
Early IDR proposals were attempts to create completely self-financing systems. To the extent anyone was subsidized, revenue from high-income borrowers would cover assistance to low-income borrowers. There is no reason, however, that protections against excessive debt burdens must be financed by higher charges to other borrowers in the loan system. Instead, plans can rely on government subsidies. For example, other countries such as the
United Kingdom and Australia that have adopted IDR have treated it as a way to partially recoup funds from what had previously been 100 percent government-funded universities. In the U.S., the 2007 creation of the income-based repayment program involved reducing some subsidies to banks in order to cover the projected costs of the new repayment plan.
Candidate Trump did not indicate whether he intended for his plan to be self-financing or not.
Who Is Eligible, at Which Institutions, for How Much Money?
The creation or expansion of financial aid programs, of any type, can influence institutional decisions about programs, tuition charges and distribution of their own aid, and student decisions about borrowing and costs. In the United Kingdom and Australia, the IDR system was created for students predominantly at public institutions, by the same governments that also set caps on tuition and monitored access. The U.S. higher education system, in contrast, involves public, nonprofit and for-profit institutions with a wide variety of incentive and control structures and no federal controls on tuition. Further, loans are available to undergraduate and graduate students, with wide ranges of loan limits. In 2006, a new federal loan program was enacted, known as Grad Plus because they are
federal Plus loans for graduate and professional students. Plus loans can finance the entire cost of a student’s education with no set limit, meaning that the higher a college raises its tuition, the more loan money it can claim. (Other federal loans are capped at levels well below the total cost of attendance at most institutions, preventing colleges from getting more money from loans through tuition hikes.) There is evidence that this moral hazard is causing tuition increases in some programs, such as law, that rely on borrowing for a large proportion of their students. The hazard can be made worse by IDR because borrowers expecting relatively low incomes have no financial incentive to limit their borrowing because the size of the loan balance does not affect the repayment amount.
Candidate Trump did not indicate which loans or students would be eligible for his student loan plan.
How are Incomes to Be Documented and Payments Processed?
An oft-repeated lesson of implemented IDR programs is that documenting income can be a major administrative hurdle. The current federal programs create the need for additional procedures for borrowers whose incomes have declined, because payments are based not on current income (as would occur through a payroll withholding system) but instead on a review of prior-year income tax filings. Payroll withholding, such as through the income tax system, can be far more efficient, but is not without its own complications. Someone must still instigate the withholding and determine the right amount to be withheld, given the amount borrowed. There are additional complications for married borrowers (if the amount owed depends on joint income, as it does in the U.S. programs), and borrowers who are self-employed or have multiple sources of income.
President-elect Trump has not indicated whether he intends to use the existing loan servicing system or a different approach.
How Is the Program Treated in the Income Tax System?
The tax treatment of IDR programs has long created complications. Loans are generally not treated as income, but forgiven debts are generally considered income subject to taxation, while grant aid is usually taxable to the extent it exceeds tuition and other course-related expenses. As it stands today, amounts forgiven in the U.S. loan program (except under service-related provisions) are subject to taxation, which means that the “end” of repayment under the loan formula may not actually be the end of payments for the borrower.
The president-elect has yet not indicated whether he will fix this problem.