Are interest-free loans a simple solution to the student debt crisis?

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Diving Brief:

  • Federal policymakers should offer interest-free student loans to prevent borrowers from paying more than the original value of their loans, according to a Boston-based nonprofit group focused on college affordability and lobbying against student debt .
  • Proposal, described in a report from the Hildreth Institute, seeks to address the growing number of borrowers who find themselves trapped in negative amortization loans – borrowers making payments on their loans that do not cover accrued interest, resulting in a loan balance that increase.
  • Under Hildreth’s plan, the government would offset the costs of interest-free loans by investing principal repayments in risk-free assets, like Federal Reserve bonds. This could generate a return that would cover administrative costs.

Overview of the dive:

President Joe Biden continues to ponder possible variations of large-scale student loan forgiveness, including a U.S. Department of Education plan that could have covered several million borrowers. That would do well on a campaign promise Biden made to forgive at least $10,000 per borrower, but critics argue Debt relief without reforming the student loan system will leave future borrowers in the same predicament as those who owe money today.

Hildreth’s proposal argues that interest-free federal loans would provide a lasting solution by preventing loan balances from skyrocketing and avoiding the need for periodic loan forgiveness.

“An unintended result of our current system means that financially distressed borrowers end up paying more over the life of their loans than wealthier borrowers,” the report said.

Some borrowers have found temporary relief under a federal student loan repayment moratorium. In response to the pandemic, the Department of Education suspended all federal student loans beginning in March 2020. Interest rates on loans fell to 0% while the Department suspended payments and halted collections overdue loans.

The relief program has been extended several times and is currently about to expire end of August.

Under Hildreth’s proposal, interest rates would stay at 0% and students could use their money to pay off their loans. For borrowers with an average debt of $35,000, an interest-free loan would reduce monthly payments under a 20-year repayment plan by $383 to $145, according to the report.

In 2019, nearly a quarter of all student loan repayments went to interest, not loan balances, according to the report. The value of those interest payments, $22.4 billion, was up from $13.1 billion in 2015.

The amount is expected to increase as interest rates on new undergraduate student loans are expected to rise from 4.99% to 5.85% over the next decade, according to a May report of the Congressional Budget Office.

Income-based repayment plans are a popular option for borrowers facing large payments, but the report says they present complexities and challenges. IDR plans allow borrowers to adjust monthly payments based on their income and family size. While this makes regular payments easier to manage and can help avoid payment defaults, it can often lead to negative amortization.

IDR plans typically last 20 or 25 years and cancel remaining debt at the end of that period. But the balance of rejected loans is taxable and has often ballooned at this point, according to the report.

Having an IDR plan with an astronomical amount attached is also stressful and disproportionately affects black borrowers and their mental health, Hildreth argued.

Nearly half of undergraduate loan balances held by black borrowers increase after graduation, compared with less than a fifth of balances held by white graduates, according to a 2016 Brookings study quoted by the report.

Among black borrowers with IDR plans, 67% said the loans had a negative impact on their mental health, according to a 2021 survey from Education Trust.

Hildreth argues that interest-free loans would be easier for the federal government to manage and would prevent borrowers from carrying the financial and mental burden of an ever-growing balance.

Robert P. Matthews