How to Clean Up the Student Loan Mess

The University of California at Berkeley. A Princeton researcher has found that the arbitrary process of loan servicers’ assigning a call to one operator instead of another has real effects on a borrower’s loan status.

Student loans are central to financing college educations, yet millions of borrowers are in default. That is clear evidence that the system is in dire need of improvement.

In fact, new research on student loans is reinforcing a key lesson of behavioral economics: Seemingly minor details matter in a major way. Who answers the phone at the loan company, what choices you’re offered and how they are framed can have profound effects on your financial well-being.

Federal policy ignores these simple truths. While the federal government owns the loans, private companies collect payments, keep records and communicate with borrowers.

It might seem trivial to worry about who collects payments on student loans. How complicated can it be to send out a monthly bill and credit a borrower’s account?

But seemingly small missteps can send a borrower spiraling into default. The loan companies have misdirected payments, lost paperwork and charged the wrong interest rate, the Consumer Financial Protection Bureau and Government Accountability Office have shown.

Say a borrower has fallen behind on her monthly payments, and her loan company calls to check in. The rules are complicated, and the responses of an individual call agent are critical.

One agent might guide her into enrolling in an income-based repayment plan that resets her payment to zero, with the balance eventually forgiven. Even if she qualifies for the income-based plan, a different agent might put her onto a less desirable path: what is known as forbearance, with her payments suspended, interest mounting and no progress made toward ending her obligation.

In a carefully designed study published in January, Daniel Herbst, a doctoral student in economics at Princeton University, examined thousands of records at a large student-loan servicer. He found that the arbitrary process of assigning a call to one operator instead of another has real effects on a borrower’s loan status. Simply being placed in an income-based repayment program slashed loan delinquency by 21 percentage points to essentially zero. Those enrolled in the income-based program were 2 percentage points more likely to hold a mortgage (a substantial increase given the baseline of 20 percent), likely reflecting an increase in homeownership. And they were paying down their student loans faster than those who were enrolled in standard plans, in which payments are fixed for 10 years and do not vary with income.

All this points to lower default rates for people on income-based plans. In such plans, payments are zero for the very lowest earners and a percentage of income for those with higher pay. Reducing default matters, because it can have devastating personal consequences, including damaged credit ratings and reduced job and housing prospects because employers and landlords check credit reports.

The bottom line is that the decisions made during loan servicing matter enormously to the financial well-being of millions of people. Market pressures alone won’t improve the student loan industry because borrowers are locked to the servicer selected for them by the government and can’t vote with their feet.

This leaves the government as the only real hope for keeping servicers in line. Yet the Trump administration has scaled back oversight of the loan companies. The Consumer Financial Protection Bureau, which acted as a loan watchdog under the Obama administration, has been relatively quiescent the past year. In fact, Mick Mulvaney, its new director, is seeking legislation that would weaken the agency.

In the absence of federal action, some states have stepped in to protect borrowers. But in response to industry complaints, the secretary of education, Betsy DeVos, has warned state regulators not to supervise loan companies, claiming her department has sole jurisdiction over them. Even if the states continue to persevere, their actions won’t substitute for comprehensive federal oversight.

What’s the solution? We could make the loan system less difficult for borrowers to navigate. In particular, borrowers should be enrolled automatically in an income-based program if they fall behind on their payments. The lengthy process for enrolling and staying in these programs should be simplified, with tax records used to automatically determine payments.

Even better would be a system of payroll withholding, like those in England and Australia, where loan payments automatically fluctuate with earnings. Some people oppose this approach, arguing that payroll deduction elevates student loans over food and rent as payment priorities. But this misses the strongest protection of payroll withholding: It automatically cuts payments to zero when earnings drop low enough, putting loans at the bottom of the payment hierarchy.

As it is, we have a punishing system of garnishment in place for student loans. In 2017, the blandly named Treasury Offset Program seized $2.8 billion from student borrowers who were in default. These funds were taken from federal earned-income tax credit, Black Lung Benefits and Social Security payments that would have gone to retired, disabled or deceased workers and their families.

It makes little sense to have the federal government seize money from these most vulnerable families while shying away from a sensible system of payroll withholding for active workers.

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