New Bill Would Incentivize Defaulting on Student Debt
The Senate has taken up a bill to reform the landmark 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, and a group of Democratic Senators led by Dick Durbin (D-IL) want to include changes to student loan policy. One part of their proposed amendment appears particularly ill-conceived and is likely to create perverse incentives for borrowers with federal student loans.
The amendment would reduce the amount of money the government could garnish from a borrower’s wages if he is in default on his federal student loan. Providing relief to borrowers struggling to repay their student loans may sound like the sympathetic thing to do. But there are several reasons why it is a bad and counterproductive policy.
Under current law, a borrower who has gone more than a year without making an on-time payment on a federal student loan may have his wages garnished. While there are complicated rules about how much the government can instruct an employer to withhold from an employee’s paycheck, generally speaking wage garnishments for federal student loans cannot exceed 15 percent of a borrower’s take-home pay. The Durbin amendment would change the limit to 10 percent of income above 185 percent of poverty by household size, with a presumption that the borrower’s household includes three people. That equates to an $38,443 exemption.
The result would be a large reduction in how much borrowers have garnished currently, which is the intended outcome. But through this reduction, the amount of wages taken through garnishment would be below what a borrower would be required to pay even if he remained in good standing on his loan and repaid under the Income-Based Repayment program. That program limits payments to 10 percent of income over 150 percent of poverty by household size. Moreover, borrowers need to report their household size; there is no presumption that it includes three people.
Both situations require borrowers to pay 10 percent of income. However, under the Durbin amendment, a borrower exempts more from his income, reducing the payment. Therefore, a borrower in default who has wages that can be garnished is allowed to make lower payments on his federal student loan than a borrower with the same income but does not default. A single borrower with a $20,000 income would pay $21 a month in wage garnishment under the Durbin proposal, while he would pay $57 per month if in good standing and enrolled in Income-Based Repayment.
Not only is that unfair, it sends the wrong message to borrowers. In fact, it provides a disincentive for a borrower to cure his defaulted loan and move it from wage garnishment to good standing by enrolling in Income-Based Repayment. Why? Because if he did that, his payments would increase.
Despite the negative press about wage garnishment, the evidence shows that it is a highly effective policy. The Obama administration conducted a pilot program a few years back in which the Treasury Department went head-to-head with private collection agencies to see who could do a better job of collecting unpaid student loans. Under the pilot program, Treasury largely postponed using wage garnishment to collect defaulted loans, while private collection agencies continued to use it. The results showed that Treasury recovered just a fraction of what the collection agencies recouped and moved far fewer borrowers back into good standing on their loans. What explains the difference? Here is how Treasury put it in its report:
[Treasury] postponed using AWG [Administrative Wage Garnishment], which allows garnishment of a borrower’s wages without a court order, for a majority of borrowers for the first 11 months of the pilot. The delay not only drove the differential in wage garnishment recoveries … but likely also contributed to decreased activity generally. Since initiating AWG in January 2016, toward the tail end of the first year of the continuing pilot, there has been an increase in the number of borrowers contacting Fiscal to attempt to resolve their loans and end involuntary collections.
In other words, the threat of wage garnishment encourages borrowers to resolve their defaults far more than other approaches.
There is also evidence that reducing the amount of wages that can be garnished will weaken the effectiveness of the policy. A study released in late 2016 by New York University’s Constantine Yannelis looks at whether borrowers with the means to repay their loans would opt not to in the absence of wage garnishment policies. Using a large federal dataset, Yannelis focuses on changes in borrower repayment patterns after lawmakers instituted wage garnishment for federal student loans and raised the amount that could subject to garnishment from 10 percent to 15 percent of disposable income.
What did he find? Borrowers with the means to pay, who might have opted to ignore their debts, were dissuaded from doing so due to the threat of garnishment. And the increase in wage garnishment levels further reduced the share of borrowers who defaulted in their first three years of repayment by 2.13 percentage points. That might seem small at first glance, but relative to the current three-year cohort default rate of approximately 11 percent, it is a substantial change.
A better approach to reform the default collection policies for federal loans would align the incentives for borrowers in default to move their loan back to good standing — not increase the incentive to remain in default.
To give just one example, lawmakers could allow borrowers in wage garnishment to consolidate their debt, thus curing the default, without having to first negotiate with a collection agency to have the wage garnishment order lifted. Lawmakers could also require that collection agencies and the Department of Education request that credit bureaus wipe the default history from a borrower’s record once he consolidates the loans. (Current policy leaves the default history on a borrower’s credit record, even if a loan is moved back to good standing.)
Unlike the Durbin amendment, such reforms would simplify the processes for exiting default and increase the benefits of doing so. That’s the right approach to take with student loan reform. Help student loan borrowers get out of default, not simply make default more comfortable.
Jason D. Delisle is a resident fellow at the American Enterprise Institute.