Sunday, December 04, 2011

Kevin Carey on the Best Kind of Student Loans

The US Should Adopt Income-Based Loans Now:

Under an income-contingent loan system, like those in Australia and Britain, students pay a fixed percentage of their income toward their loans. Payments are automatically deducted from their paychecks by the IRS, just like income-tax withholding. Self-employed workers pay in quarterly installments, just as they do with their taxes. If borrowers earn a lot, their payments rise accordingly, and their loans are retired quickly. If their income falls below a certain level—say, the poverty line—they pay nothing. After an extended time period of 20 or 30 years, any remaining debt is forgiven.

In other words, nobody ever defaults on a federal student loan again. The whole concept of "default" is expunged from the system. No more collection agencies hounding people with 10 phone calls a night. No more ruined credit and dashed hopes of home-ownership. People who want to enter virtuous but lower-paid professions like social work and teaching won't be deterred by unmanageable debt. [...]

The concept has been proven to work—Australia and Britain have used it for years—and both liberals and conservatives have reason to get on board. The Nobel Prize-winning economist Milton Friedman proposed the idea all the way back in 1955.

Indeed, income-contingent loans are such a good idea, one might wonder why they don't exist already. [...]


  1. Sachin Shanbhag said...

    I think they have been tried before in the US and have failed (Clinton's "Hope Scholarships"), because of adverse selection. People who don't expect to make a lot of money like such programs, and people who expect to make a lot of money, don't sign up for such programs. As a result, such programs are not self-sustaining.

  2. Abi said...

    @Sachin: Are you sure about the Hope Scholarship? It appears to be very different from what Kevin Carey's talking about.

  3. Sachin Shanbhag said...

    Abi, I recently read Charles Wheelan's book "Naked Economics" in which there was some discussion of this (Clinton's Hope Scholarships). If you google "naked economics hope scholarship" you may be able to see the two pages of the book (on which discuss this. I'm cutting and pasting the link I get, but I don't know if it will work for you.

  4. Ankur Kulkarni said...

    @Sachin Was signing up optional in the program you mention? In that case, it obvious that it won't work. Only those whose expected payment is less than the fees will sign up. The program needs the law of averages to work.

    This may be a good model for India, and the IIT payment plan is an example of this kind of post-payment. But the problem is that evasion of payments by many might make it costlier than fees. Besides, how does one track those who have gone abroad? Also, if the money is not channelled directly to the university, but instead goes to the IRS/FinMin, then all institutions would be financially dependent on the Ministry. Putting so many eggs in a single broken basket is not advisable.

  5. Sachin Shanbhag said...

    @Ankur Yes, it was optional with the Hope scholarships - which was the reason it failed - adverse selection. I don't see how you could make it mandatory though, in the US.

  6. Dheeraj Sanghi said...

    I think the way it works is the following (let us consider only one year repayment for easy understanding). I need to take 10,000 rupees as loan. I can go to a non-government source, who will give me loan at 10%, and would insist on payment of Rs. 11,000 at the end of 1 year, irrespective of my income and financial situation. Or I could go to government, who will say the following: If your income in the year is less than a lakh of rupees, you pay nothing. If your income is more than 1 lakh than you pay 1% of your income, but you pay a maximum of Rs. 11,500, even if you earned a crore.

    Let us assume that the average income of all these people is going to be around 11 lakhs, and if everyone signed up and everyone paid up, government would also get a return of 10%, just like the bank would have. A few people who are absolutely sure of an income greater than 11 lakhs would not sign up, but note that because of the cap of 11,500, there won't be too many of these. An additional 500 rupees is giving you tremendous peace of mind. What if something happens, and I don't make that much money. The private lender will take me to court.

    If most people will sign up, and many people will give the government 15% return, then that will offset those who make much less than 11 lakhs, and even if the government gets a return of 7%, note that the private lender did not make 10% either, since it will have some defaults as well.

    So essentially the person is buying peace of mind with a slightly higher potential rate of interest, a kind of insurance scheme, if you please.