The Paradox of Pay-As-You-Earn College Loans

What should be done about expensive colleges? In the midst of the 2016 election, Senator Marco Rubio has quietly endorsed an interesting alternative to the debt-free college funding proposals of Democratic candidates Hillary Clinton and Bernie Sanders: income-based repayment loans. Also known as a pay-as-you-earn scheme, this program allows recent college graduates to pay for their college loans with a fixed share of their income rather than a fixed amount of money. Although they seem simple at first glance, IBR loans are actually a complex economic interaction completely dependent on expectations, trust and optimism.

Year after year, the rising price of a college education continues to put a high burden on the finances of American families and young people. Measured in current dollars, the average price of tuition in a public college has risen from $500 dollars in 1971 to $9139 dollars in 2015. This increase has occurred simultaneously with a shift in the American economy away from manufacturing. People without college diplomas realize lower earnings, a higher unemployment rate and a higher chance of living in poverty. Today, the increasingly expensive college diploma is more valuable than ever.

This need for an expensive college education would probably push many people towards taking out an IBR loan. After all, the benefits of IBR are obvious to many college graduates struggling to pay their students loans.  The job and salary you get after college do not really matter, because your payments are not absolute but relative to your whole income. IBR loans bring more financial security and allow for a more relaxed financial planning in the early adult years of graduate life.

However, to determine if whether this is a worthwhile transaction, one should not only examine the benefits but also the costs, which is where IBR loans become trickier. The payment flexibility in IBR loans also produce a variability in costs, both for the borrower and the lender. As such, assessing the net economic gain of this type of loans depend on our attitudes towards our own future.

Imagine you major in an obscure dead language and you know for sure you won’t be making lots of money in the future. As you assume you will probably be unemployed after graduation, the benefits of IBR seem perfectly fitting for you. This situation is not the same for someone majoring in finance or engineering. You know you will probably have a higher than average income after college.  If you know you won’t have trouble paying back your loans, why would you sign an IBR agreement and effectively subsidize your friends majoring in obscure subjects? The future investment bankers and petroleum engineers will effectively self-select out of the lending pool. This counterproductive scenario occurred when Yale University implemented a similar program called “Tuition Postponement Option” from 1971 to 1978. High earning graduates complained they were paying more than their fair share of their debt obligation, which decreased money from the pool and increased the share that lower earning graduates had to give back.

No loan system can really be successful if all the borrowers are pessimistic about their economic futures. Lenders will have to carefully analyze the conditions of the loans for students, which could create powerful economic distortions. For example, to incentivize higher earning graduates to sign up, lenders could lower the share of their income to be repaid in the future. Undoubtedly, this would create economic pressure on college students to choose careers that are profitable rather than important but less profitable professions, such as education, research and non-profit work. Similarly, assessing the future success of a future graduate could also allow for more pernicious forms of discrimination. Racial and gender biases could subtly influence the conditions and allocation of IBR loans.

If IBR loans are to be the future of college funding, all of these potential negative consequence need to be addressed. The economic incentives between high and low paying majors will need to be carefully managed to avoid a negative social externalities. Federal agencies will need to ensure a bias-free allocation process in the private and public sector. Considering that most current college loan systems need to be reformed, it is important not to forget the true potential benefits of properly managed IBR loans to thousands of American students. The expansion of IBR loans could be a very effective tool to decrease a massive economic burden of the byzantine American college system.

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