The Case for Obama's Fixes to Income-Based Repayment

President Obama’s fiscal year 2015 budget would curtail some of the windfall loan forgiveness benefits that the Income-Based Repayment program for federal student loans now provides to graduate students and borrowers who go on to earn high incomes. Recall that these benefits were introduced in the program when the Obama administration and Congress cut borrowers payments under IBR by 33 percent and shortened the loan forgiveness term from 25 to 20 years of payments. Those changes also upped the ante for graduate and professional schools – and their students – looking to fully finance their programs using the  Public Service Loan Forgiveness Program (i.e. Georgetown Law). The president’s proposed changes will, “ensure that the program is well-targeted and provides a safeguard against rising tuition at high-cost institutions."

In 2012, we recommended a series of fixes that lawmakers could make to address these problems, without fully rolling back the increased benefits that the Obama administration added to IBR in 2010 and 2012. Our proposals were meant to leave the Obama administration’s changes intact for the lowest earning borrowers and students with debt from undergraduate studies. Meanwhile, our proposals would add “circuit breakers” to IBR so that borrowers with debt from graduate school who earn middle and high incomes are less likely to have a large portion of their educations financed by taxpayers when they can afford to repay their debts. Ultimately, our goal was to improve the program so that it provides a safety net for all borrowers whose educational investments lead to unexpectedly burdensome debt and does not at the same time provide a de facto tuition subsidy for graduate school. Our changes would only apply to future borrowers, not those who have loans now or are about to start borrowing.

The Obama administration’s fiscal year 2015 budget proposes most of the fixes we recommended in this effort (see here for side-by-side comparison). But it includes some variations, leaves one out, and adds something new altogether. The question is: Do our proposals, as modified under the president’s budget, still accomplish the goals stated above?

They go a long way. Here is why, with a few caveats about how they fall short.

Create Two-Tiered Loan Forgiveness:

We proposed in our 2012 paper that borrowers who enter repayment with more than $40,000 in debt should not qualify for loan forgiveness unless they had made payments based on their incomes for 25 years, rather than 20 years under current law. The administration proposes the same policy, but would set the threshold at $57,500 in debt – the maximum that a dependent undergraduate student can borrow.

The intention behind this proposal was to set up different terms for those with undergraduate debt (or moderate amounts of graduate school debt) and those who borrow large amounts to finance a graduate education. Loan forgiveness is a safety net, but the time period after which loans are forgiven has to bear some relation to the amount borrowed. Otherwise what is a safety net for someone borrowing $30,000 becomes a tuition assistance program for someone borrowing $100,000. Moreover, because IBR lets people make payments at 10% of income (after deductions for pre-tax benefits and at least another $17,500 exemption on top of that) the resulting payments are too low for someone earning even a high income to fully repay their loan in 20 years.

Eliminate the Payment Cap:

IBR includes two maximum monthly payments: one based solely on income and the other based on the 10-year standard repayment rate (10 years of fixed payments that fully repay the original loan balance). Both types of payments count toward the loan forgiveness time period. Effectively, the cap ensures that once a borrower’s income is high enough that he no longer qualifies for reduced payments under IBR, his payments become a declining share of his income. We and the Obama administration would eliminate this cap, and only payments under IBR would count toward loan forgiveness.

The rationale for this change is straightforward. Payments should always be based on income if the program is also going to provide loan forgiveness after a set period of time. To be sure, the cap actually plays a relatively small role in IBR’s mix of benefits that allow borrowers with higher incomes to qualify for significant loan forgiveness. The other provisions play a much larger role.

Base Payments on Household Income:

IBR does not require that a married borrower include his spouse’s income in his adjusted gross income if he files his federal income taxes separately from his spouse’s (married, filing separately). We recommended that payments be made off of combined household income, unless both borrowers were paying loans under IBR, in which case it would be 50 percent of household income. The Obama administration budget recommends the first part of this, but doesn’t specify how two-borrower households would be treated. We assume the administration would support halving household income for two-borrower households.

The rationale for the change is that basing IBR payments off only the borrower’s income rather than household income allows a borrower who himself has a lower income, but belongs to a high-income household, to receive larger amounts of loan forgiveness than his financial situation would warrant. Furthermore, allowing borrowers to exclude spousal income by filing separate taxes doesn’t fit with another part of IBR’s design. The program adjusts payments to household size as part of its formula. A married borrower can claim a two-person exemption ($23,595) rather than a single exemption ($17,505), reducing his monthly payment by $50. The exemption for a four-person household ($35,775) would result in payments that are $153 less per month than for a single borrower.

Allowing borrowers to exclude income from a spouse through separate tax filing is ripe for abuse by savvy borrowers. A borrower repaying through IBR could move all of his family’s pre-tax benefits (e.g. 401k, flex and dependent care accounts, health insurance premiums) to his paycheck to lower his adjusted gross income. That could cut his loan payments by as much as $200 a month and add tens of thousands to the amount forgiven. He can than also count his spouse in his family size and claim a larger exemption under the IBR formula, even though he has filed his taxes separately. And he could then count his children in his household size, too, if he provides for “more than half their support,” a nebulous standard that is practically impossible for the U.S. Department of Education to enforce. As a result of this collection of provisions, someone with a household income of $175,000 could easily have his IBR payments based on only $40,000 of income.

Limit Public Service Loan Forgiveness, Don't Limit Final Loan Forgiveness:

Lawmakers need to decide how much public support they want to provide to borrowers working in the non-profit and government sectors. In creating Public Service Loan Forgiveness, they left the program completely open ended. There theoretically is no limit to what a borrower can have forgiven. That wouldn’t be so much of an issue if they didn’t also allow those borrowers to make very low payments on their loans for just 10 years before qualifying for forgiveness.

We proposed a $30,000 limit based on the logic that the federal government should provide no more in aid to someone with a masters or professional degree (really the only people who can get large benefits under PSLF due to loan limits and having to make 10 years of payments) for working in a “public service” job than it does to students from the poorest families in the form of Pell Grants to pay for an undergraduate education. We still think that is a good proxy – and $30,000 in loan forgiveness is a large benefit. It is more than most undergraduate students borrow. The Obama administration has proposed a $57,500 limit based on the logic that undergraduates can borrow up to that amount in federal student loans.

Limitless Public Service Loan Forgiveness leads to very unequal benefits at best, and outright abuse at worst. With regard to the former, why should someone who borrowed $250,000 to attend law school receive a larger benefit than someone who borrowed $60,000? And on the latter point about abuse, students attending graduate school may have a good sense of what their incomes will be in the first 10 years after school (a social worker, a teacher, etc.) and can therefore approximate the point at which borrowing another $10,000 to pay for school or living expenses won’t increase his payments because it will be forgiven. That point of “no marginal repayment” can hit when borrowers reach balances as low as $25,000 or $30,000. Schools can take advantage of that dynamic, too, and jack up prices for graduate degrees. Then there is Georgetown Law’s LRAP program. You can read more about that here and here.

Separate from Public Service Loan Forgiveness, we argued that IBR’s final loan forgiveness (after 20 or 25 years) should be left without a limit. That is how the program provides a safety net. If you haven’t repaid by that length of time, your debt is forgiven. Putting a limit on it would obviate that function. Public Service Loan Forgiveness is not a safety net; IBR is the safety net. Public Service Loan Forgiveness is a federal subsidy for certain sectors of the economy and it can serve that purpose even if it is subject to a limit.

Finally, it is important to keep in mind that once a borrower has received his loan forgiveness for public service, he can still make payments on any remaining balance using Income-Based Repayment and still qualify for loan forgiveness after IBR’s other forgiveness benefits kick in (in this case after 10 or 15 more years of payments).

Two Points Where the Proposals Differ:

Higher Payment Rates for All But Lowest Income Borrowers:

We proposed that a higher payment rate for borrowers earning more than $35,000 a year be added to IBR. Borrowers earning below that level would pay at 10 percent of adjusted gross income (after the 150 percent of poverty exemption) and borrowers earning above it would pay 15 percent of income (after the 150 percent of poverty exemption). The Obama administration fiscal year 2015 budget doesn’t propose any changes to the payment rates—it  leaves them at 10 percent for all borrowers regardless of income.

We added this provision because we found that even after extending the loan forgiveness term for borrowers with debt that exceeds $40,000, the program would still allow borrowers with middle and even high incomes to qualify for substantial loan forgiveness if they had borrowed for graduate school. Allowing borrowers to make payments on 10 percent of their incomes, after exempting pre-tax benefits and at least $17,500 (more for a larger family), results in monthly payments that are too low to pay off debts from graduate school for someone who is earning a salary commensurate with their credential.

Generally, it makes sense under an income-based repayment system that the lower the payments are as a share of income the longer their term for loan forgiveness should be. That is, if borrowers are to pay a smaller share of their incomes, then they will need longer to fully repay the debt – or at least it will take longer to determine who could eventually repay and who probably won’t. About the time the Obama administration proposed both lowering payments and shortening the loan forgiveness term under IBR, the U.K. amended its income-based repayment program, also lowering the share of income on which payments would be based. Except, the U.K. then lengthened the loan forgiveness term from 25 to 30 years of payments.

Forgiving Accruing Interest Early:

The president’s fiscal year 2015 budget proposes a new benefit to the Income-Based Repayment (IBR) program for federal student loans. Unpaid, accrued interest would be “capped at 50 percent” on a monthly basis. For example, a borrower whose payment is only $50 under IBR, but whose loan accrues $100 of interest in one month, has the remaining $50 in unpaid interest immediately cut in half. It is forgiven. Without this benefit, the borrower waits until the final loan forgiveness term to have any unpaid interest forgiven, but his monthly payments are unchanged either way. Or, alternatively, if his income later increases, he pays off the accrued interest before the final loan forgiveness term. Our proposed changes to IBR did not include a provision like this. (As an important note, interest generally doesn’t compound in IBR, it just accrues, so borrowers are not charged interest on interest to any meaningful degree.)

Forgiving interest as it accrues rather than as part of a final loan forgiveness term is actually a regressive benefit when added to IBR. It provides the largest benefit to borrowers who would have repaid the interest anyway later in the loan term. And it provides no added benefit to borrowers with perpetually high debt-to-income ratios because they would have had the accrued interest forgiven eventually at the end of the repayment term. Most importantly, the benefit can never reduce monthly payments. Those are based solely on income under the existing Income-Based Repayment terms. So the benefit does not affect the affordability of the loan.

For example, with the proposed new benefit in place, a borrower earning $45,000 a year with an $80,000 loan (6% interest rate) would have $83 forgiven every month, but if his income later increases and he fully repays his loan, the interest he had forgiven earlier is never repaid. It is a benefit he pockets even though he goes on to earn a high income. If his income stays at $45,000 indefinitely, forgiving the interest earlier as it was accrued changes nothing for him because it would have been forgiven at the end of his loan term anyway. It doesn’t affect the total payments unless he goes on to earn a higher income.

Congress Should Act:

Now that the Obama administration has proposed changes to Income-Based Repayment that would curtail some of the windfall loan forgiveness benefits the program provides to graduate students and borrowers who go on to earn high incomes, it’s up to Congress to draft a bill. We think lawmakers should adopt all of the proposed changes – except the regressive interest forgiveness benefit – and go a little further.

To reiterate, the changes that the Obama administration has embraced go a long way to fixing IBR, though its benefits may still be too large for lawmakers to make it a universal Income-Based Repayment program, a goal we support. Importantly, these changes must only apply to future borrowers, not those who have loans now or are about to start borrowing.

Finally, lawmakers should use any savings that these changes generate in the budget to make IBR’s benefits uniform across existing borrowers and future borrowers. Alternatively, plowing the savings back into the Pell Grant program for low income undergraduates would also be a good use of that money.