Tweaking the Gainful Employment Repayment Rate

The U.S. Department of Education is hosting its next negotiation session around gainful employment from Monday to Wednesday next week. One of the key issues to be discussed is the Department’s new proposal for a federal student loan repayment rate. This measure was in the final version of the regulations published in 2011, but concerns about the threshold chosen on this indicator led to a judge striking down the whole rule. While the repayment rate did not make it into the Department’s first new proposal for gainful employment, which was released in August, it returned in the second version released last week. The repayment rate partially closes a loophole that could have allowed programs to have lots of dropouts with debt, but it’s not perfect. There are still several key issues the negotiators need to address to make the repayment rate work properly.

Define the Repayment Rate Cohort

The other gainful employment measures all have defined cohorts and minimum sizes. For the debt-to-earnings rates, a program must have at least 10 students that graduated three or four years ago whose earnings can be matched to the Social Security Administration. For the program cohort default rate it is at least 30 borrowers, which can be either in a single year or over a period of multiple years.

The repayment rate currently lacks a defined cohort. That means a program with one borrower could theoretically be subject to this test, which would be unfair. The negotiators need to solve this issue by choosing a minimum cohort size. The two obvious choices would be either 10 to mirror the debt-to-earnings rate or 30 to mirror the program cohort default rate.

Avoid the Single Year Comparison

The new repayment rate operates under a different formula from the one used in 2011. Rather than measuring the percentage of individual loans that are being repaid, it looks at the performance of the entire loan amount taken out by students that attended a program. A program passes the repayment rate test if the total principal balance owed at the end of an award year is less than what it was at the start of that same year. (See the bottom of this post for a more technical explanation of how these formulas produce different results.)

But this formula as described by the Department has the potential to either unfairly help or penalize programs, with the overall issue being it’s not sufficiently tolerant of irregular payment patterns.

The repayment rate formula as described by the Department has the potential to either unfairly help or penalize programs, with the overall issue being it’s not sufficiently tolerant of irregular payment patterns.

For struggling programs, the one-year test is potentially flawed because of deferment or forbearance, which could allow borrowers in a program to make no payments for several years and still pass with one year of good payments. Consider a program with a cumulative principal balance of $100,000 when it enters repayment. If the borrowers struggle and are in deferment and forbearance over the course of two years the total debt would accumulate interest and grow to $107,869 by the start of year three. But that $107,869 is treated as the new principal balance owed. That’s because when someone exits deferment or forbearance, that unpaid interest is capitalized, meaning the total principal balance becomes the old principal amount plus the unpaid interest. Now, let’s say borrowers make enough payments in year three to keep up with interest plus $1 more—about $4,165. At the end of the year, the principal balance is $107,868, lower than it was at the start of the year and enough to pass the repayment test. It’s passing even though the actual principal owed is nearly $8,000 more than it was when they entered repayment. The one good year made up for two years of bad results.

The one-year repayment test can also work against good programs. Let’s say that same group of borrowers that owe $100,000 are very debt averse for the first two years and end up making a lot of prepayments on their loans to the point where they reduce what they owe to $70,000 after one year. But now they take it easy for the next year and don’t’ make any payments above interest because they've already made pre-payments so they do not owe as much money each month. In this case, the principal balance would grow and a program would fail the repayment test, even though the actual principal balance owed is well below what it was at the start of repayment.

The result is that the test as described is a better proxy for how well borrowers happened to do in years three or four, not how well they’ve done during their entire time in repayment.

Better Alternatives

Instead of treating repayment results in a way that only looks at results from the start to end of a year, the calculation should take into account the original principal balance when the loans first entered repayment. Doing so avoids any need to deal with capitalized interest from deferment or forbearance. It also makes for two very easy ways to design a repayment rate test.

The first, as outlined in “Improving Gainful Employment,” would be to look at whether the amount of outstanding principal at the end of the fourth year in repayment is less than the principal balance when the loans entered repayment. This test would reward programs with a lot of prepayments at some point since the balance at the end of year four would still likely be lower. But a program with heavy utilization of deferment and forbearance would likely fail because any capitalized interest would make it harder to get the debt balance back to where it was when it entered repayment.

Now, it’s possible that test may be seen as too weak. In that case, the repayment test could take the starting principal balance and ask how much should still be outstanding after four years if the borrowers are going to repay their debt within a specific period of time. In other words, if borrowers owe $X at the start of repayment and are going to pay it off over 10 years, how much should $X be at the end of year four? It looks at whether the cumulative performance to date suggests the loans will be paid off in an acceptable and defined timeframe. Those that pay them off fast enough pass, those that would take too long fail.

The likeliest time thresholds would be 10 years (the standard repayment time), 12 years (the amount of time borrowers on average take to repay), or 20 years (the amount of time before loans would get forgiveness under new income-based plans). The toughness of the test gets weaker as time to repay gets longer since borrowers would not reduce their principal as quickly.

A Valuable Measure in need of Tweaks

Repayment rates are a useful accountability measure for making sure borrowers are actually paying down their debt, not just avoiding the ultimate consequence of default. But for this measure to work properly, it needs a clearly defined cohort that pegs off the original balance owed. Beyond that, negotiators should keep it simple and avoid other unnecessary alterations or complications.

How the Formulas Differ

Consider a cohort of borrowers A, B, and C. Borrowers A and B each owe $10,000 in principal and C owes $30,000 in principal, making the total loan debt for the program $50,000. In the last award year, borrower C made all of her scheduled payments and her principal balance owed is now $28,000. Borrowers A and B were not so fortunate, and their balances went from $10,000 to $12,000. Under the 2011 calculation, the repayment rate of the program is 60 percent—out of a total balance borrowed of $50,000, borrower C’s original balance of $30,000 is being repaid. This is true even though only one out of the three borrowers is actually repaying her loans. Since the repayment rate is above 35 percent, the program passes.

Under the Department’s new proposal, the program fails the repayment rate test. That is because the balance at the end of the year is $52,000 ($28,000 for borrower C plus $12,000 each for A and B), which is more than the $50,000 the program owed at the beginning of the year."