Earlier this year a new bill was introduced to Congress called the Student Loan Forgiveness Act of 2012.
The potential legislation has some massive changes for the student loan industry. Is this new student debt legislation a good idea or something that should be shelved by Congress?
What is the Student Loan Forgiveness Act?
The Act would make wide changes to the massive student debt load in the country.
In 2010 total student loan debt exceeded total credit card debt for the first time. The Act is also in response to a poor economy: the idea is that former students are too cash strapped from paying their loans to spend any money in the economy and relieving them of this debt would greatly improve the consumer economy.
10/10 Payment and Forgiveness
The first major part of the law is what is being called “10/10” where the student loan payments would be kept at 10% of a borrower’s discretionary income.
After 10 years of consistent payments, under certain rules, they could qualify for forgiveness of the remaining amount of the loan. For borrower’s that fall after the Act becomes a law, their forgiveness would be limited to $45,520 in principal, fees, and interest. For borrower’s that had loans before the Act becomes law, there is no cap. That means someone who has been paying their loans for 120 months could, in theory, wipe away the remaining debt immediately if the legislation is passed into law.
Capped Interest Rates
With this legislation all federal student loans would be capped at 3.4%. Currently undergraduate loans that are subsidized by the government are at 3.4%. However, undergraduate unsubsidized and graduate unsubsidized loans are currently at 6.8%.
Better Public Service Loan Forgiveness
The legislation would also drop the number of months you would need to have in public service for loan forgiveness.
Currently you must be employed for 10 years (120 payments) before loan forgiveness kicks in. Under the new legislation that would be cut in half to 5 years (60 payments).
Should the Student Loan Forgiveness Act Be Voted Into Law?
Forgiving massive amounts of debt across the country (now estimated to be more than $1 trillion) is bound to free up some extra dollars to be spent within the economy, right? That spending would result in job growth, tax revenue growth, and so forth.
Even if that were all true there is a serious flaw to this and other loan forgiveness ideas.
How Credit and Lending Works
It all revolves around how credit works.
When I let you borrow money from me, that loan is based on trust and qualifications. I believe that you will do everything you can to pay me back. I’ll charge a fair interest rate for the risk I am accepting which is normally set by market conditions. If I wanted to charge you more than the market did, you could go elsewhere, so I play along.
You get your loan (and education) and I get to earn some investment income. We both win because I had trust that you would pay the loan back.
Now change the rules to where loans can be “forgiven”.
From a lender perspective that sound an awful lot like “written off” which means “I lent money and never got paid back”. You’re telling me I should want to continue to loan money to someone that, in a few years, would have the option of not paying the balance back to me? No right minded lender would accept this situation and simply stop lending. To do otherwise would be insane. You don’t lend money to people who can walk away whenever they feel like it — at least not without being able to charge an adequate interest rate.
Those interest rates is the second problem.
Let’s say I’m willing to take the risk that you will walk away from the loan at some point in the future like you would with a credit card. As a reaction to this increased risk, I would then charge an increased rate so that my investment return comes out about the same. While the government controls the Federal loan interest rates, they cannot control the private market. And private student loan rates would skyrocket to compensate for the increased risk.
The third problem is financing the loan forgiveness.
Let’s say all $1 trillion of the estimated student loan debt out there is Federal loans. If Congress passes the law that wipes out that debt, that’s $1 trillion the United States won’t be paid back. (Plus any interest that would have been earned. At just 3.4% and $1 trillion, that would be $34 billion per year.) Our current national debt is about $16 trillion. You would then immediately bump up that amount to $17 trillion. (Not to mention trying to explain to your fellow taxpayer that the increased taxes he pays in the future are to pay for your free student loans while he paid for college by working his way through or saving up like a financially wise person.)
What do you think?
Should we as a country allow widespread loan “forgiveness”? There are tempting numbers — $1 trillion in debt that could be used in the consumer economy — to consider. But are the risks too great?