Tweaking student loan repayment system could dramatically reduce defaults

December 25, 2020
Students sit on the lawn at Yale University in New Haven, Connecticut. (Bob Child, AP)

Students sit on the lawn at Yale University in New Haven, Connecticut. (Bob Child, AP)

A proposed minor change to the administration of student loans would dramatically reduce the number of borrowers who default on payments each year, according to a new study by three U.S. economists. 

The paper, published in the December issue of the Journal of Public Economics, showed that changing the default repayment plan for federal student loans from the standard fixed minimum payment plan to the pre-existing income-driven repayment option would significantly reduce the number of defaults. 

Currently, 25% of student loan borrowers default on their loans within five years of finishing school, the researchers said, even though a U.S. Treasury Department study found that 70% of borrowers who defaulted met the criteria for enrolling in an income-driven repayment plan, which would have protected them against default.

“It’s clear that people are being harmed by the current choice framework,” said co-author Daniel Kreisman, a professor of economics at Georgia State University, in an interview.  “Making policy without taking into account the reality of human behavior is a mistake.” 

Kreisman, who conducted the research along with James C. Cox of Georgia State and Susan Dynarski of the University of Michigan, said the results prove that the federal government should change its default repayment option. 

The experiment design was relatively simple: a control group of subjects were given a mock-up of the current federal student loan website with the standard repayment default options and asked to select a plan. An experimental group was given an identical site, except an income-driven repayment option called "Revised Pay As You Earn” was the default option. 

Researchers incentivized the subjects, 542 Georgia State undergraduates who had completed at least one year of school, by telling them they would receive a percentage of what recent college graduates might expect to earn over each of the next 25 years, minus living expenses and any payments due on the student loan plan they selected. 

The control group selected the standard fixed minimum payment plan about 63% of the time, which the researchers said was in line with the real-world proportion among current borrowers. By comparison, the experimental group selected the fixed minimum payment plan just 34% of the time. 

“The only takeaway from this is that you should change the default option,” said Kreisman, who holds a doctorate from the University of Chicago. 

The paper’s publication comes amid a raging debate around student loan debt forgiveness. 

As Senate Minority Leader Chuck Schumer pushes President-elect Joe Biden to forgive $50,000 in student debt per borrower, a working paper on the topic by Sylvain Catherine of the University of Pennsylvania and Constantine Yannelis of the University Chicago has been circulating among economists this month. In it, Catherine and Yannelis argue that forgiveness of student loans would be regressive in present value terms because people with high incomes generally take out larger loans and because low earners can have much lower payments under income-driven repayment plans. 

Kreisman said his research is smaller in scale — exploring the behavioral effects of a bureaucratic tweak rather than the overall effects of wholesale loan forgiveness — but he appreciates Catherine and Yannelis’ findings. 

“A lot of the people that are going to have significant amounts of debt are people that are going to be doctors, MBAs,” he said. “There’s a lot of room for [forgiveness] to be regressive.”

The researcher argued his finding will be useful even if lawmakers were to wipe out all student debt on day one of Biden’s administration. Colleges and universities will still charge tuition, causing students to continue to take out debt.

An ideal student loan repayment model may be similar to those of the U.K., Canada and Australia, where income-driven repayment is the automatic and only option for student loans, he said. Kreisman is hopeful change might be coming soon for U.S. student loan policy, he said, because there is a broader public conversation about student debt now than when he began the study in 2017. 

“That you’re calling me and the words student loan pop up on my newsfeed every day means that people are thinking about it,” he said. 

Kreisman, Cox and Dynarski conducted the study in 2017, released it as a working paper in 2018 then published the final version in the Journal of Public Economics in December of this year. 

The researchers also tested the effects of providing simplified information about repayment terms, as well as giving subjects information about their future earnings expectations. Neither of these factors led to a significant change in repayment plan choice alone. However, giving subjects information about future earnings combined with changing the repayment plan to income-driven significantly increased selection of the income-driven plan. 

“This suggests that availability of earnings information may nudge behavior more effectively when choice of income-invariant repayment plan requires a decision to actively switch plans,” the researchers said. 

The paper, titled “Designed to fail: Effects of the default option and information complexity on student loan repayment,” was published in the December issue of the Journal of Public Economics. James C. Cox and Daniel Kreisman of Georgia State University, as well as Susan Dynarski of the University of Michigan, were co-authors. Cox was lead author. 

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