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Atif Mian and Amir Sufi: The case for student loan indexing

The burden of student debt has exploded over the past decade, and economists worry that it is holding back the recovery by depressing home-buying and spending among young adults.

The federal government plays a major role in the student debt markets; 85 percent of all outstanding student loans are owed to the government. Policymakers are now debating reform of student loan programs, and their decisions will have an enormous impact on the manner in which students finance higher education.

We believe they should recognize that the central problem with student loans is that they force graduates to bear a disproportionate amount of risk for circumstances completely outside their control.

In October 2007, the unemployment rate among the previous spring’s college graduates was 8.5 percent. In October 2009, the unemployment rate for the comparable cadre of recent graduates jumped to almost 18 percent. This enormous rise was because of a nationwide economic shock — the Great Recession — that was beyond the control of any student.

In fact, when the Class of 2009 entered college in 2005, its members had good reason to be optimistic. The economy appeared strong, and job opportunities for graduates were excellent. Students took on debt believing that they could easily pay it back. But after the recession hit, many could not find jobs or accepted low wages.

You might think that the problems facing the Class of 2009 were temporary: Once the economy strengthens, they will be fine. You would be wrong. Research shows that students who graduate in an economic downturn see lower wages and worse jobs long into the future. The effects are large, negative and persistent.

But what happens to their debt obligations? Even when the job market plummets, student loans have the same principal balance and require the same interest payment. Debt does not adjust, even though the economic circumstances of the graduates have changed dramatically.

This makes no sense. Inflexible student-debt contracts place an unfair burden on young Americans. This flaw could be addressed by indexing federal student loans to the unemployment rate new graduates face.

For example, the government might use the average unemployment rate of recent graduates in normal, non-recessionary years — which a variety of estimates suggest is around 6 percent — as a benchmark. In any year when that average is higher, the government could automatically and permanently lower graduating students’ principal balance by, say, 5 percent for every percentage point that the average is above the benchmark. In this example, a student who owed $10,000 upon graduation in 2009 — when the average unemployment rate for recent graduates was 18 percent — would see a reduction in the principal balance of $6,000. A formula like this would ensure that students who graduate into the worst job markets would get the most debt relief.

This kind of contract is better because it shares the risk associated with economic downturns. And because it gives these graduates more buying power, it would address the government’s charge to stabilize the economy.

President Obama has proposed a debt reform that would make interest payments contingent on the income of the graduate, which is a step in the right direction. In a downturn, the average income of graduates would decline, and their payments would be lower.

However, that proposal provides perverse incentives that could defeat its purpose. It is based on the individual’s job and income, not aggregate economic conditions, so a graduate could lower his interest payment by taking a lower-paying job, or perhaps by turning a job down. A program that automatically lowered all student-debt burdens in a weak economy would better preserve incentives as well as risk-sharing.

Closer to our idea is a proposal from Sen. Elizabeth Warren, D-Mass., that would allow students to refinance into lower rates. It also would act as a type of insurance, because rates tend to fall in recessions. We would support this proposal but, as we’ve seen with the mortgage market, refinancing doesn’t always work well, particularly for individuals with low credit scores. Some former students won’t be aware of the opportunity. Others might not find a willing lender. We worry that a large number of eligible students would not be able to use this proposal.

In our indexing proposal, interest payments would automatically come down for all students when economic conditions deteriorate. It would not rely on graduates seeking refinancing.

Further, we believe that graduates should get more than just an interest-rate reduction if economic conditions deteriorate sufficiently — principal, too, should be forgiven. For example, the government could forgive the debts of students who graduated in 2008, 2009 and 2010 — in a horrible job market.

Student debt as currently structured is flawed because it forces students to bear undeserved risk. Many students understand that this risk is large and may therefore avoid going to college altogether. This is a disastrous outcome. We need a better student loan program that provides both the opportunity to go to college and insurance in case the economy collapses.

Atif Mian is a professor of economics and public policy at Princeton University. Amir Sufi is a professor of finance at the University of Chicago Booth School of Business. This column ran first in The Washington Post.

Graduating With Student Debt? Take This 10 Question Quiz

In the college commencement speeches making headlines this graduation season, a few of the usual themes emerged: find your passion, as Fed chair Janet Yellen preached to a crowd of NYU grads; recover from a “soul-scorching” loss with resilience and grace, as ousted New York Times editor Jill Abramson told  Wake Forest grads; take risks and bet on yourself, as  It’s Always Sunny In Philadelphia star Charlie Day implored Merrimack students.

The one piece of advice the graduates didn’t get, but probably should have? How to pay back their student loans.

The graduating Class of 2014 is the most indebted in history, with 70% of the newly-minted undergraduate degree holders carrying an average debt of $33,000 each. Many, it’s safe to say, don’t know what they’ve taken on when it comes to repayment.

True, those who have federal student loans are supposed to complete a student loan exit counseling session – either through a personalized session provided by a student’s school (usually online, sometimes in person) or this generic federal online version. Yet in a recent survey by NERA Economic Consulting and advocacy group Young Invincibles,  40% of federal borrowers reported they had not received any exit counseling at all. Young Invincibles deputy director Rory O’Sullivan doesn’t think that means schools are simply ignoring the exit counseling mandate, but rather that the exit counseling students did receive was so inadequate that it made no impression.  “The quality of the survey, the quality of the exit counseling, isn’t up to the point that people recognize that it’s counseling in the first place. It’s an online thing, a lot of information, and schools don’t do a good job making sure students are learning it,” he says.

That’s also what Carol Jensen, author of “College Financial Aid: Highlighting the Small Print of Student Loans,” found in reporting her book.  She says that while schools notify students that they need to take exit counseling, there’s very little follow-through to make sure the students have actually gone through the counseling session, let alone that they understand the information in it.  “Students just click ‘yes, I understand’ and move forward,” she says.

Problem is, this isn’t an iTunes terms of service agreement (or one of those alcohol surveys that so many college freshman snooze through each year) that you can safely click and ignore. It’s essential information that could affect your life and finances for the next 10, 20 even 25 years.

Good exit counseling should by scary. Michael Thompson, a 2014 master’s graduate of the University of Illinois at Urbana-Champaign, noted that his experience with exit counseling is that it “wastes no time in telling you the worst news first,” opening with an awe-inspiring, “Dear student, you owe X.”

Despite the shock that can come from seeing that final tally, Thompson agrees that “it is far too easy for any participant to go through the motions of the module simply as a means to completion,” admitting that even he, a budget-conscious student from a blue collar background, is guilty of this.

So in the interest of a more informed (and yes, financially responsible) student debtor Class of 2014, Forbes has come up with our own 10 question student debt “exit test.”  If you have debt, give it a whirl:

1.  What’s the first thing you should do about your student loans?

A. Get organized

B. Transfer the balance to a 0% interest credit card – gets rid of the interest!

C. Flee the country and change your name.

Answer: A. By no means ignore your debt by fleeing the country (more on that later) and by no means transfer it to a credit card that will swap the 0% rate for one that’s 22% after a year. Getting organized is your best bet.

“I occasionally find people at Tuition.IO who find a loan they didn’t realize they had. With a change of address [after graduation], things get lost,” says Wilton Risenhoover, chief technology officer for student loan tracking service Tuition.IO. “Getting a definitive list of your loans and when they’re due – that’s the single most important thing a borrower needs to do.”

The best way to get organized is to go to NSLDS.ed.gov, which will show you all your federal loans and their servicers, and annualcreditreport.com to make sure you’ve tracked all your private loans as well. Student loan tracking sites like Tuition.IO and Student Loan Hero (which has a $5 monthly fee) are also ways to stay organized. For more in-depth advice about organizing your loans, check out this article here.

2.  How much debt do you have?

A. $0

B. $20,000 or less

C. $20,001 to $50,000

D. $50,0001 or more

E. I don’t know

Answer: If you’ve gone to any of the sites mentioned above, you should be able to make a list with each loan amount. Add it up, and that will give you an idea of your total debt load. (Ideally, you would have done this when you got your financial aid award letter, but they can be confusing and hard to read, so if you’re just figuring out your total indebtedness no one is judging you.)

3. What are the interest rates on your loans?

A. 3.86% and fixed

B. 4.66% and variable

C. 6.8%

D. Other

E. It might as well be 100% for all I care

Answer: If you have multiple loans from different sources, there’s a decent chance you have a fun assortment of interest rates. It’s important to know what they are for a number of reasons:

First, knowing which rates are highest can help determine which loans, if any, you throw extra money towards in order to pay them down faster. Even more importantly, knowing your interest rates will help you determine exactly what your monthly payment will be – and this number will, in turn, show you exactly how burdensome your debt is, and help you make other decisions, such as how much rent you can pay and whether you can afford a car.

Using the numbers you discovered in questions #2 and #3, head to a repayment calculator here, here or here. Different experts have different rules of thumb about how large a monthly payment is too large – Carol Jensen, for instance, says anything higher than 7% of your monthly take-home pay will be too hard to swing, while other guidelines say 10% to 15% should be your max – but if comparing your monthly obligation to your monthly income produces a number that makes it seem like you can’t meet other financial obligations (like rent or transportation costs), you may want to look into alternate repayment plans such as  Pay As You Earn, Income-Based Repayment (IBR) and Income-Contingent Repayment (ICR), alternate payment plans that are available for most federally guaranteed loans. Pay As Your Earn caps payments at 10% of your discretionary income and extends the repayment period from the standard 10 years to 20 years. IBR extends the repayment period to 25 years and caps payments at 15% of your discretionary income; ICR also extends the repayment period to 25 years and caps payments at 20% of your monthly discretionary income.

Why Obama's Proposed Budget Has a Bunch of Public Service Workers Worried About Their Student Debt

I spoke with dual tyro debt experts—lawyers Adam Minsky of Boston and Heather Jarvis of North Carolina—about a proposal.

In online forums, and in some of a emails Boston.com has perceived in our call for tyro debt stories, people now enrolled in PSLF have voiced regard as to either they would see loans already in amends subjected to a top if a offer came to light. However, both Minsky and Jarvis consider it’s intensely doubtful that any change to a module would impact stream debtors. Instead, stream debtors would expected be grandfathered in to a stream capless system.

They indicate to a fact that a promissory records students pointer privately discuss intensity redemption programs—meaning it competence be bootleg to simply lift an about-face. What’s more, they say, it’s tough to suppose such a blatant act opposite people who competence already be several years into a PSLF program, that would volume to pulling a carpet out from underneath a era of open use workers. Student debt website Educated Risk also sites an preparation dialect spokesperson, vocalization on background, as observant a offer would not impact stream borrowers.

So it during slightest appears that stream debtors shouldn’t worry too most about descending theme to a cap. Still, Minsky and Jarvis say, a top offer could have vital disastrous effects on destiny students looking to go into open use or nonprofit work.

To be clear, $57,500—the due top for forgiveness—is still a lot of income to get absolved of. However, it competence not paint unequivocally most during all for a series of tyro debtors. That’s since of a conflation of a few factors.

The first: PSLF usually requires smallest payments in sequence to see forgiveness. Those authorised are also means to use a government’s income-based amends or pay-as-you-earn options, that concede for monthly loan payments to adjust formed on what a debtor owes. But many open use or nonprofit positions don’t compensate unequivocally most in a initial place, and so debtors payments breeze adult hardly putting most of a hole in their sum debt, nevermind a principal.

Which segues into indicate two: Due to high seductiveness rates and low monthly payments, it’s imminently probable for somebody creation payments underneath PSLF to see their debt fundamentally mount still or even boost over a 10 years of payments. So if somebody graduates with, say, $80,000 of debt, it competence seem like it would be unequivocally easy for them to hit that down to $57,500 by a time a 10 years is up—but in fact, their debt competence indeed be even aloft than a $80,000 sum they started out with. (The offer could be looked during as an incentive-by-fire for open use workers to make incomparable payments during their amends period, so as to be underneath or nearby that $57,500 line when their 10 years are up.)

And finally, it’s value observant that many open use jobs—like many positions in propagandize systems, for example—require students to acquire an modernized degree. So while it’s easy to contend students shouldn’t have taken on so most debt in a initial place, that’s not unequivocally satisfactory when some positions need costly connoisseur degrees.

The voices of those debtors, however, don’t seem to be during a heart of a proposal. Instead, a order change appears to be meant to aim colleges themselves. The thought is that underneath a stream system, schools competence feel empowered to keep on lifting tuitions if they consider they can assistance students find jobs that would validate for forgiveness. The New America Foundation, that spearheaded most of a president’s proposal, highlights a module during Georgetown Law School (legally) gamed a complement to make a Juris Doctorate radically giveaway for both a tyro and a school—thus putting a cost of an chosen law propagandize preparation roughly wholly during a responsibility of a sovereign government. By capping forgiveness, speculation holds, schools wouldn’t be means to sell redemption as a probable out from all a debt students incur, and so competence be reduction tempted to lift tuition.

Few would contend schools and their ever-rising fee prices are but copiousness of censure as tyro debt continues to balloon. And Minsky and Jarvis, a tyro debt experts we spoke with, concurred programs like Georgetown’s competence consecrate a problem. But Minsky says capping redemption for everybody enrolled in PSLF programs ignores a infancy of those who mount to advantage from a program, whose degrees are value a lot reduction than a Georgetown law degree—like teachers, superintendence counselors, and those who work during foundations or charities.

Jarvis adds that if a thought of a offer is to use caps to discourage tuition, it‘s substantially too early to contend it would even work. She points out that it will still be a few years before anybody sees loan redemption underneath PSLF, and that hasn’t stopped colleges from lifting fee year after year.

Minsky and Jarvis counsel that a president’s bill offer is only that—a proposal. In a stream divided domestic climate, it’s during slightest as expected that any bill offer flunks rather than passes.

Could Falling Mortgage Rates Spur Housing Growth?

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The little-known student loan bait and switch

 

Ever been promised something with a couple of strings attached, only to have more and more added the closer you got to your goal?

That appears to be what co-signers of private student loans are experiencing, at least according to the mid-year update from the Consumer Financial Protection Bureau (CFPB). Family members who agreed to be held contingently liable for the loans their children and grandchildren undertook were told they would be released from their contractual obligations after a certain number of prompt payments. Only later did they learn that they would remain on the hook for months and, sometimes, years more.

Complaints about this are rampant. Not only do the extensions of co-signer commitments appear to be arbitrarily determined, but there are also reports of absurdly cumbersome paperwork and unspecified or unilaterally modified credit-underwriting requirements. Worse yet, loans have been automatically placed into default and aggressive legal actions taken when co-signers have passed away or declared bankruptcy — even if the borrower is current on the loan.

In its purest form, the fundamental thinking behind co-signed debt is straightforward. The primary borrower lacks sufficient credit history, acceptable past-payment performance or adequate cash flow to assure the repayment of the loan that’s under consideration. So the lender conditions its approval on the creditworthiness of a back-up borrower, who would be called upon to make good on that debt should the primary borrower fail to make the payments.

What appears to have happened, however, is that instead of requiring co-signers as a last resort, private education lenders now routinely lead with that stipulation. In fact, as more financial institutions jump into the student-loan refinancing pool, co-obligation is an advertised prerequisite.

Workable Solutions — Or Not?

All this taken into account, the CFPB makes three suggestions at the conclusion of its report. To start, the bureau would like to see the loan servicers take the time following the death of a co-signer to determine whether the primary borrower is now able to meet his or her obligations without the added support of a replacement co-signer. If not, then perhaps the primary borrower can convince a deceased person’s spouse or some other family member to step into the original co-signer’s shoes. And, if all else fails, the bureau would like to see the lenders grant to the primary borrower additional time to refinance his or her loan with another lender.

As sensible and well-intentioned as these suggestions sound, they are, unfortunately, naïve, for a simple reason: Neither the CFPB nor the borrowers nor the co-signers have any negotiating leverage.

Releases of co-obligation, re-evaluations of creditworthiness and waivers of so-called events of default all track back to the terms and conditions that are part and parcel of a contract all the parties — including the lender — consented to upfront. Consequently, all of them would have to agree to modify those same terms in order to carry out the bureau’s recommendations. Moreover, unless the lenders (or subsequent note holders, when the loans are sold to others) have formally delegated credit-underwriting responsibilities and documentation modification authorities to their subcontracted loan servicers, the servicers will not be in a position to release or replace any co-signer. In fact, it’s even possible that the lender could end up with two co-signers, unless the first is released as soon as the second comes aboard.

As for the suggestion that the lender give the borrower more time to refinance his loan, let’s take a moment to ponder that. If the borrower doesn’t have what it takes to qualify for standalone credit with his current lender, how likely is it that he will be able to accomplish that with an institution that doesn’t know him?

What Borrowers Can Do

The vast majority of private student loans that have gone “live” are co-signed. Unless Congress decides to right these wrongs, all that any borrower or co-signer who finds himself in this type of predicament can hope for is to negotiate the most favorable outcome the lender is willing to concede.

Going forward, however, prospective private student borrowers who are compelled to deliver loan co-signers in exchange for the financing they want would be wise to demand four concessions.

Justify the need. Many private lenders appear to have adopted a stance that all loans require co-signers and that the applications must include this additional credit-background information in order to be processed. Prospective borrowers should instead insist that lenders first evaluate their creditworthiness on a stand-alone basis. I’ve heard from college grads who’ve established themselves in their chosen careers and are now contemplating refinancing their student loans: all were asked for co-signers even before the lenders reviewed their initial applications. So they pushed back — hard — and the lenders yielded.

Limit the term. When there is a legitimate need for a co-signer, it’s important to cap the duration. Three years is a reasonable amount of time for a new borrower to begin to settle into a career and build credit. Therefore, it makes sense to negotiate for a coincidental sunset on the co-signer’s obligation. As for the typical requirement of lenders for prompt payments during those first three years, negotiate for the insertion of the word “reasonably” before “prompt.” Student borrowers are financial neophytes: They’re more likely than most to trip up at first — not because they lack the cash, but because they’re new to the process. As long as their missteps aren’t chronic, lenders should be willing to cut them some slack. Accordingly, “prompt” should be defined in the contract as “less than 30 days past due.”

Re-justify the need when conditions change. In the event that a co-signer dies or encounters irresolvable financial difficulties before that third anniversary, the borrower’s credit standing should be re-evaluated before any other action is taken. The basis for that re-evaluation — such as minimum acceptable FICO scores and maximum acceptable levels of debt to income — needs to be spelled out upfront.

Ensure the release. As soon as the third anniversary is reached—or if a co-signer is to be released for other reasons — it is important that the loan documentation provide for the immediate and unconditional termination of his or her contingent obligation.

Whether it’s because borrowers and their families are typically inexperienced in these matters, or that they felt they had no other choice at the time (Federal Direct Loans are a better option), it’s obvious that the private student-lending industry has gotten the better part of the bargain for a long time.

The question is: Have education borrowers finally reached the point where enough is enough?

[Editor’s Note: If you’d like to refinance your student loans or get a co-signer off of your current loan, it’s important to work on your credit. You can track two of your credit scores for free every month and get a personalized action plan on Credit.com.]

This story is an Op/Ed contribution to Credit.com and does not necessarily represent the views of the company or its affiliates.

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