Following recent reports focusing on predictive indicators that a borrower will default on his or her student loans, a new paper from the American Enterprise Institute (AEI) highlights what happens after students default and urges policymakers to simplify the options, and rethink the penalties, associated with defaulting to relieve both borrowers and taxpayers.
The report, released in conjunction with a study from the Urban Institute on how borrowers’ debts outside of their student loans can speak to whether they will enter into default, used newly-available data from the National Center for Education Statistics (NCES) that tracked the federal loans of students who enrolled in the 2003-04 academic year over the course of 13 years. For the purpose of this report, authors Preston Cooper, Jason Delisle, and Cody Christensen analyzed data from the 2,607 borrowers who defaulted at least once and found that many make no progress repaying their loans, and see their overall loan balances rise even after exiting default.
“While policymakers should continue to address default prevention, some of their attention should shift to how borrowers can exit default,” they wrote. “The current maze of inconsistent fees, penalties, and paperwork that borrowers must navigate to exit default is ripe for change.”
The authors cautioned in the report, however, that the cohort of students they analyzed may not be representative of students today, as they enrolled in higher education over a decade ago, and that the effects of new policies increasing in popularity, such as income-driven repayment (IDR) plans, are not captured in this report.
The authors opened their report by highlighting that, contrary to popular belief, default “is not a permanent status.” In fact, a majority of borrowers (70 percent) actually exited default within five years, they found. Specifically, 13 percent of students exited default after just one year, 52 percent after three years, and 62 percent after five years. The remaining 8 percent exited during the “intervening five years.”
Borrowers do differ, however, in what methods they use to exit default. In the report the authors distinguish between “hard exits” and “soft exits” for defaulters, which they define as a full payoff, or through rehabilitation and consolidation, respectively.
The authors found that 31 percent of defaulters exited default by fully paying off their loans within a few years, which they hypothesized might have been because their balances were often relatively smaller to begin with. More than half of those borrowers had less than $10,000 in debt when they entered into default, and a third had less than $5,000 in debt.
Other borrowers exited default by rehabilitating or consolidating their loans, however the authors found that these borrowers overall did not show progress toward paying down their debt. In fact, they found that in the five years that they observed “trends in the balances of borrowers who exit default through rehabilitation or consolidation are barely distinguishable from those who do nothing to exit default,” and that these borrowers usually see their loans increase by 10 percent during this time. The authors wrote that this increase may be the result of taking on new federal loans, as well as collection fees. Additionally, the authors found that 41 percent of these borrowers defaulted again on their loans, which led them to conclude that rehabilitation and consolidation “are not effective at resolving a borrower’s risk of default for good.”
To that end, the authors suggested that policymakers combine the options for rehabilitation and consolidation, which come with their own unique requirements and fees, into one option dubbed “resolution,” in an effort to simplify the system for existing default. They also recommended that policymakers delay borrowers’ ability to take on more loans after this choosing this option until they can “demonstrate an ability and willingness to make payments.” They suggested that policymakers codify this by requiring that borrowers make at least 12 payments on time after “resolution” before taking out new loans.
In addition, the authors wrote that the various ways that borrowers going through the process of default are treated is “inconsistent” and often “overly punitive,” as there are harsher penalties, such as collection fees, for a borrower who repays his or her loans in full quickly after defaulting than for those who enter rehabilitation and make no progress repaying their loans. Under the current system, for example, borrowers with $7,000 in loans can have their collection fees waived through a settlement, pay $9 if they rehabilitate the loan, pay $102 if they are involuntarily subject to a tax refund offset, or pay $2,000 if they pay off the loans voluntarily through periodic installments.
The authors suggested that policymakers streamline the consequences associated with defaulting on loans by replacing this mix of fees with one charge that would applied to the loan at the time of default, which they wrote “reduces costs for borrowers compared with deducting fees from each payment.”
They also recommended charging borrowers fees for wage garnishment to relieve taxpayers and employers of the administrative costs associated with that collection process, and removing a default from a borrower’s credit report after they fully pay off their loans, whereas now it is only cleared if they enter rehabilitation.
“As today’s high rates of student loan default show few signs of slowing down, there is plenty of room for policymakers to standardize collection fees and create a single, fast process for borrowers to exit default,” the authors wrote. “In the meantime, observers should reconsider the common conception of default as a permanent or catastrophic situation.”
Publication Date: 8/17/2018