Thursday, September 8, 2016

Is IBR the best way to provide student loan debt relief?

Is IBR the best way to provide student loan debt relief?

The Income Based Replacement (IBR) Loan Program is a program implemented by the Obama Administration in order to provide debt relief to overextended student borrowers.  This post considers the advantages and disadvantages of the IBR program.

Description of IBR program:  The primary objective of the IBR program is to help student borrowers avoid defaulting on their loans when their household income is low.  This is accomplished by linking student debt to household income.

Under the IBR program, the required student loan payment is $0 when household income is less than 150% of the federal poverty line.  When household income is more than 150% of the federal poverty line, the IBR payment is the minimum of 15% of disposable income or the standard payment on a 10 year-student loan. (Disposable income is defined as household income minus 150% of the federal poverty line.)  Individuals with family income exceeding 15% of disposable income will make the standard payment for a 10-year loan.

Other important features of the IBR program include:

Government payments of monthly interest for up to three consecutive years if the IBR payment does not cover monthly interest under the 10-year repayment plan,

No capitalization of interest when income is less than 15% of disposable income,

Remaining balance on the loan is forgiven after twenty five years,

Facilitates eligibility for public loan forgiveness for student borrowers employed by public service organizations.

IBR Issues:

Will many student borrowers take advantage of the IBR program?

The take-up rate for the IBR program is low and is likely to remain low for several reasons.

Private student loans, PLUS loans made to parents and any consolidated loan with a PLUS loan made to parents or a private loan are not eligible for IBR.  Students who are not aware of the rules of the program when they are taking out or consolidating their loans will not be able to take full advantage of the IBR program.  Moreover, in many instances the potential savings from enrolling in an IRB program will be small or even zero when a household has large amounts of credit card debt and/or ineligible student loans.

Many student loan borrowers are likely to prefer a 20-year fixed rate loan over a 10-year loan that is eligible for reduced IBR payments.  The IBR loan payment increases with income and reverts to the standard payment on a 10-year loan once household income rises above 15% of household income. The standard payment based on the 10-year amortization schedule may be unaffordable if the household has other debts.  A student borrower who chooses IBR over a 20-year loan may be forced to consolidate into a 20-year loan with a higher payment than what he would have been charged if he chose the 20-year fixed option when beginning repayment

In many instances, married households must file separate returns in order to obtain full (in some cases any) advantage of the IBR program.  The decision to file separate returns generally increases a household’s tax obligation.   Separate returns can lead to higher marginal tax rates for the spouse with the higher income and loss of considerable tax deductions.  Ideally student borrowers should consider this issue when they are debating different payment options.  However, at that point in time most student borrowers are single and not thinking of potential future tax obligations when married.

Will student borrowers who take advantage of IBR receive a large government subsidy?

Student borrowers who pay the reduced IBR monthly payment rather than the 10-year scheduled payment will have their loan extended past ten years. As a result, many borrowers who take advantage of the IBR program in order to receive lower monthly payments will end up paying more on their student loan than they would have if they had maintained their scheduled payment under a 10-year payment plan.  Also, as noted above many married student borrowers who take advantage of the IBR program will pay more in federal income tax over their lifetime.
Debt forgiveness after 25 years will only occur when a student borrower has chronically high levels of debt in relation to disposable income.

The Treasury Department in 2015 ruled that any student loans forgiven under the IBR program will be treated as taxable cancellation of debt that must be reported on the income tax form.

For many student borrowers, this ruling will create a large new debt due immediately upon the cancellation of any remaining student loan.

Should the IBR loan program be made more generous?

The Obama Administration proposes to make the IBR program more generous by reducing the lBR payment to 10% of disposable income (from the current level of 15% of disposable income) and by allowing for loan forgiveness after 20 years rather than after 25 years.   A recent study by the New America Foundation found that these changes benefit mostly higher-income borrowers. 

New America Foundation Report on IBR

Some quick comments on the NAF report:
The NAF foundation report contains case studies that examine how different types of borrowers fare under the old IBR program, the IBR program proposed by the Obama Administration, and standard 10-year or 20-year loans.  One of the borrowers evaluated in this report is Robert an affluent lawyer.  Under the newly proposed IBR program Robert would have $160,536 of debt forgiven after working 20 years even though he had a $164,000 annual salary.  The NAF report does not state whether Robert’s example or any of the other examples considered in the report are typical or atypical.  A more informative analysis would consider typical income paths and debt levels for particular professions.  Lawyers are not a beloved profession and choosing Robert to be a lawyer rather than say a cancer researcher or an osteopath definitely sets the reader’s mood.

Whether the IBR actually provides more benefits to higher income groups is an empirical issue that can only be addressed with actual data on the finances of IBR participants.

Does the IBR program encourage individuals to borrow more? 

Under the current IBR payment formula, the actual amount a student borrower must repay if his debt level is more than 15% of disposable income is independent of the amount the student borrowed.  Under these circumstances, the required payment is 15% of income, regardless of how much the student debtor borrowed.

Despite the possibility of free money the number of students who increase their debt levels because of the IBR program may be fairly low.  Many student borrowers, especially students at private undergraduate schools, borrow the maximum allowable amount of public loans and even rely on private loans and PLUS loans to parents.  Most student borrowers do not know their future earnings, marital status, and family size factors that impact their IBR benefits.

The IBR program does create an incentive for some people with a great deal of foresight to increase their use of student loans.  A modification of the IBR loan forgiveness formula could substantially reduce the incentive for increased borrowing.  Rather than forgiving debt after 25 years the IBR program should set an interest rate at 0% after 15 years.  This alternative form of debt relief would keep repayment obligations monotonically related to initial debt levels, while still providing generous debt relief.

Also, the U.S. Treasury might not treat an interest reduction as taxable income to the recipient.   Under current law the Treasury treats forgiven student debt after 25 years in the IBR program as taxable income.  

Concluding thoughts:

The IBR program is an interesting option but is likely not well suited for many student borrowers.  As a result, I believe fewer people than anticipated will contribute to the IBR program and that the costs to the taxpayer will also be lower than anticipated. 

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