The best way to improve how student loan borrowers are treated is to change the incentives for their loan servicers. That happened this week.
The Headline News
President Obama signed a Presidential Memorandum earlier this week greatly expanding the Pay As You Earn (PAYE) student loan repayment program. Under PAYE, eligible borrowers’ monthly payments will be capped at 10% of their adjusted gross income, and any balance of the student loans remaining after 20 years of payments will be forgiven. This week’s Presidential initiative was to extend PAYE to most federal student loans, not just ones entered into after October 1, 2007 as had been the case until now.
The Kink in the System
Although PAYE itself has been in effect only since 2012, various income-based repayment programs have been around for about twenty years. But they have not been used by borrowers as much as had been expected. There are a number of reasons for this, but perhaps the most important one is that borrowers have been discouraged—directly and indirectly—from applying for these programs by the loan servicing companies that the federal government contracts with to collect and service the loans.
These student loan servicing companies—such as Sallie Mae, Nelnet, and Great Lakes Educational Loan Services—are supposed to help borrowers who are having trouble making payments by informing them about their options, including those that would lower their monthly payments. Various student advocates, including agencies and officials within the federal government itself, have strongly criticized the loan servicing companies—and the U.S. Department of Education which contracts with these companies—for failing to inform borrowers about the lower payment programs and helping them apply for them.
The Consumer Financial Protection Bureau—the federal consumer watchdog—has criticized the student loan servicing companies’ shortcomings in a report issued a few months ago.
And in a speech a couple months ago, the deputy secretary of the Treasury Department, Sarah Bloom Raskin, questioned why so many millions of student loan borrowers have defaulted on their loans in spite of the available income-based repayment plans. She suggested that the defaults were at least in part the result of poor loan servicing, and that servicers should be “ready to offer that borrower [in trouble] a repayment program that gives him or her the best chance of successfully repaying their loans.”
Working Out This Kink
One big reason that servicers do not sufficiently promote the income-based repayment plans is that the ways they are paid do not give them incentives to do so.
More than a year ago, the U.S. Education Department significantly reduced commissions it paid loan servicers and collectors on payments made by borrowers on defaulted student loans. Because income-based repayment plans help prevent borrowers from getting into default, this change in the commission structure took away a disincentive for offering the lower income-based repayments to those who qualify for them.
This Week’s Announcement
As this Monday’s “Factsheet” from the White House stated:
The Department of Education administers the federal student loan program through performance-based contracts with private companies awarded through a competitive process. [T]hese contracts provide companies with incentives to find new and innovative ways to best serve students and taxpayers and to ensure that borrowers are repaying their loans.
Now the Department intends to again
renegotiate its contracts with federal loan servicers to strengthen financial incentives to help borrowers repay their loans on time, lower payments for servicers when loans enter delinquency or default, and increase the value of borrowers’ customer satisfaction when allocating new loan volume.
In other words, the Administration now intends to reward servicers by giving better incentives for keeping borrowers out of default, and to penalize them by steering new student loan servicing business away from those which do not serve borrowers well.
This week’s significant expansion of the Pay As You Earn repayment program will only be successful if these rewards and penalties will be meaningful and effective.