What Should Be Done About the Coming Tsunami of Student Loan Defaults?

There is a massive tsunami of student loan defaults on the horizon. The Department of Education (ED) recently noted that 1,800 colleges—out of around 5,500—have at least 25 percent of their recent student loan borrowers failing to repay their student loans. If that remains the case into next year, many of these colleges will be at risk of losing access to federal financial aid based on their Cohort Default Rate.

Background on Cohort Default Rates

The Cohort Default Rate (CDR), established in the 1990s and amended several times, measures how many students default on their student loans within three years of beginning repayment, with default defined as the borrower being at least 270 days behind on payments.

If 40 percent of a college’s student borrowers default within three years, the college loses access to student loan programs. If the college’s CDR is above 30 percent for three years, it loses access to the student loan and the Pell Grant program. So, if nothing changes for the 1,800 colleges with nonrepayment rates above 25 percent, many may exceed the 30 percent or 40 percent default-rate thresholds.

Why Is This Tsunami Coming Now

This tsunami is coming now because, during COVID-19, both the Trump and Biden administrations repeatedly paused student loan payments. As a result, most borrowers did not have to make payments for three and a half years. Even after repayments restarted, borrowers who didn’t repay faced no consequences for a year thanks to the so-called On-Ramp. This means many borrowers didn’t repay for four and a half years and faced no negative consequences. Millions of borrowers who tried to enroll in the SAVE repayment plan also received extensions, many of which are still in effect. In other words, some borrowers haven’t made a student loan payment since March 2020. This likely reduces repayment salience and awareness and makes repaying your loans seem like something only suckers do.

Essentially, the tsunami is coming because borrowers are now being required to repay their student loans after years in which they were not required to make payments or faced no consequences for failing to do so.

What Should Be Done

There is some good news. Defaulted student loans were recently transferred from the ED to the Treasury Department (USDT). USDT inherited a deeply flawed process for getting students out of default. For instance, students often had to mail or fax their paperwork, which simply doesn’t make sense in this day and age. There was even a computer bug that told some students trying to get out of default that they had no student loans. Rather than put band-aids on a broken process, USDT overhauled the system and recently launched the Defaulted Loans Support Center, which simplified, clarified, and streamlined the process. This effectively ends the wild goose chase that some students previously needed to navigate to get out of default.

But we also need borrowers to want to get out of default. Some of this will be spurred by outreach from colleges and loan servicers. Colleges in danger of losing access to federal aid programs will be much more interested in making sure their students know they need to repay. But borrowers also need to recognize and act on their responsibility to repay their debt.

Three policy reforms should also be implemented.

The first is to turn back on two tools that encourage and, in many cases, force borrowers to repay. Administrative Wage Garnishment (AWG) allows the government to take up to 15 percent of a defaulted borrower’s paycheck. The USDT Offset Program (TOP) allows the government to withhold government funds such as tax refunds or benefits that would have been sent to a borrower and apply those funds to the borrower’s student loan balance instead. Both AWG and TOP have been turned off, partly to allow the new repayment plans to be set up and partly to avoid angering borrowers before the upcoming election. Both AWG and TOP should be turned back on. This would not only collect substantial funds, but it would also nudge borrowers to take the reins by repaying, rehabilitating, or consolidating their defaulted loans.

Second, we need a better way to deal with those who will never be able to repay. Even with AWG and TOP, some borrowers will never be able to repay their loans. Stories about low-income octogenarians having their Social Security checks garnished to repay loans they took out decades ago are a PR nightmare that will collect minuscule amounts of money for taxpayers while providing enormous fuel for those pushing to forgive all student loan debt. To address these cases, perhaps borrowers could have their remaining debt forgiven once their payments exceed what they would have paid under the Repayment Assistance Plan, which forgives any remaining debt after 30 years of payments. We could also update settlement thresholds. Right now, the most generous settlement offer allowed is 90 percent of unpaid principal and accrued interest. That figure could become variable rather than fixed, with lower percentages for each year a borrower has been under the poverty line or for repaying certain fractions of the original amount borrowed. The goal is to get borrowers and balances that will never be repaid—and that the private sector would have written off long ago—off the books without creating severe moral hazard problems.

Third, we should move beyond default rates. Income-driven repayment is the right choice for student loans, as it prevents defaults from short-term liquidity issues rather than true insolvency. However, it also renders default rates all but meaningless. We should replace CDR metrics with repayment-rate metrics, such as the percent of a cohort’s total debt that has been repaid.

The tsunami of student loan defaults is coming. If the only response Washington musters is to temporarily wave the default rate accountability metric, we will have missed a golden opportunity to fix long-standing but neglected problems with the student loan system.