As our higher education system gets costlier, taking on student debt gets easier. Colleges make it simple for students to borrow by packaging several different types of federal loans in a single financial aid letter. Sometimes, the schools even give students more loans than they need. The students just have to accept the package and deal with the loans when they leave college, whether they graduate or not.
Then, the harsh reality kicks in. Faced with looming loan payments, our young borrowers must navigate complicated and sometimes treacherous repayment options. These decisions are even harder for students who drop out, since they do not typically undergo exit counseling. With all these challenges, what's a college student to do?
Students often borrow a mix of different types of loans, which means that they need to understand the specific terms of each loan. They need to know whether their loans accrue interest while in college, whether they grant a grace period after college, what interest rates their lenders charge and which repayment plans they are eligible for. For federal loans, the government currently offers seven repayment plans, plus the Public Service Loan Forgiveness program. For private loans, students must contact each provider to investigate if any special repayment plan is available.
Choosing among the many repayment plans and recognizing the long-term implications is no easy feat. These plans can significantly reduce students' monthly loan payments, but at a price: the loan payment is extended by 20 to 25 years, meaning the amount of interest students must repay can double or even triple. This can be an attractive option for borrowers who qualify for loan forgiveness, but there is still a catch: the government charges income tax on the forgiven portion of the loan. This can easily reach $10,000 for someone who borrows over $30,000 but earns a low salary*.
There are seemingly endless trade-offs for each repayment plan, and of course, they vary for each borrower. But, by now you get the point: How can we realistically expect our young graduates to figure all this out? Even with the best counseling, there are important long-term implications that are difficult for a 20 something to grasp. President Obama's recent proposal to simplify repayment options to a modified version of the "Pay As You Earn" plan can help, but it will also introduce moral hazard. That is, once the system is simplified, it will encourage students to over-borrow, enter the income based-repayment program and get their debt forgiven without ever paying income tax on the unpaid portion of the loan.
You may be thinking: "So what? The students will be fine." And they will be. But over-borrowing will allow schools to keep increasing tuition, while taxpayers like you and me foot the bill of an increasingly expensive student loan program. Need I remind you of the $21.8 billion shortfall in student loan profit that is projected in the government's 2016 budget?
*The president has recently proposed to eliminate the requirement to pay income tax on the forgiven portion of a loan (see: http://www.whitehouse.gov/the-press-office/2015/01/17/fact-sheet-simpler-fairer-tax-code-responsibly-invests-middle-class-fami)