Question

The federal government subsidizes some loans to college students. Typically, the more students who participate in these programs and the more they borrow, the higher the cost to the federal government. In 2011, President Barack Obama convinced Congress to pass these changes to the federal student loan programs: (1) Payments were capped at 10 percent of a borrower's discretionary income; (2) any unpaid balances for people working for government or in the nonprofit sector were forgiven after making 120 monthly payments (10 years' worth of payments); and (3) people working in the private sector had their loans forgiven after making 240 monthly payments (20 years of payments). a. As a result of these changes in the federal student loan program, would you predict that the total amount that students borrowed under these programs increased or decreased? Briefly explain. b. As part of his 2016 federal budget proposal, President Obama recommended significant changes to the federal student loan programs. Given your answer to part (a), do you think President Obama was likely to have recommended changes that would increase or changes that would decrease the payments that borrowers would have to make? Briefly explain. c. How might President Obama and his advisers have failed to correctly forecast the effects of the 2011 changes to the loan programs?

Short answer

a. The total amount students borrowed is predicted to have increased, due to more favorable repayment terms and loan forgiveness conditions. b. President Obama would likely recommend changes that decrease the payments borrowers have to make, given the probable increase in student borrowing following the 2011 changes. c. President Obama and his advisers might have failed to forecast the effects of the 2011 changes by underestimating the student response to these new borrowing incentives, or not fully considering the cost to the government from loan forgiveness.

Step-by-step solution

Understand the New Loan Program Changes

Understand the three key changes to the federal student loan program made in 2011, capped payments at 10% of discretionary income, loans are forgiven after 10 years for government or nonprofit employees and after 20 years for those in the private sector.

Predict Borrowing Behavior

Examine the potential influence of these changes on student borrowing behavior. The new conditions might incentivize more borrowing, as the repayment is now income-based and not completely tied to the loan amount. Also, the provision of loan forgiveness after a certain period could encourage more students to participate in the program.

Evaluate Possible 2016 Changes

Examine the potential effects of further changes to the loan program. If the total borrowing increased due to the 2011 changes, which led to higher cost for the federal government, President Obama might suggest changes aimed at reducing overall student borrowing or making the repayment terms less generous.

Forecasting Failures

Consider possible reasons why President Obama and his advisers might have failed to correctly forecast the effects of the 2011 changes to the loan programs, such as underestimating student response to new borrowing incentives, or not fully considering the increased government expense resulting from loan forgiveness.

Key concepts

Student Loan Borrowing Behavior

Understanding how student borrowers react to loan program changes is crucial for policymakers. The 2011 federal student loan program modifications put a cap on repayments at 10% of a borrower's discretionary income and introduced loan forgiveness after a set number of payments. These changes tailored payments to borrowers’ income, potentially reducing the fear of insurmountable debt and providing clear light at the end of the repayment tunnel.

These incentives undoubtedly affected borrowing behavior, likely leading to an increase in both the number of borrowers and the amounts they borrowed. Why? Because the risk associated with debt repayment diminished. Firstly, payments became more manageable relative to income, rather than a fixed sum that might be unrealistic for some graduates. Secondly, loan forgiveness promised a finite payment period, making the loans inherently less daunting. These changes can encourage students to invest in higher education who might otherwise have been deterred by the prospect of heavy debt.

Income-Based Loan Repayment

Income-based repayment plans are revolutionary in that they adjust monthly loan payments according to how much borrowers earn, rather than how much they owe. This means that during periods of lower earnings, such as right after graduation or during a job transition, borrowers won't be overburdened by student loan payments.

The implementation of income-based repayment in the federal loan program acknowledges that career trajectories can be volatile and that graduates might not immediately secure high-paying jobs. These plans protect borrowers from default, which can have detrimental effects on credit scores and financial stability. However, income-based plans can result in borrowers paying more interest over time if they only make the minimum payment because the loan balance can decrease more slowly than with a standard repayment plan.

Student Loan Forgiveness Policy

Loan forgiveness policies effectively erase the remaining debt after a borrower has made a certain number of payments. Such policies aim to alleviate the long-term burden of educational loans, especially for those in public service or non-profit sectors.

Under the 2011 changes, borrowers in these sectors had their remaining balances forgiven after making 120 monthly payments. This not only incentivizes a career in public service but also serves as a form of financial support for those often earning less than their private-sector counterparts. For those in the private sector, forgiveness after 240 payments also offers some solace but raises questions about long-term financial planning and the balance between incentivizing education and fostering a culture of responsible borrowing.

Educational Loan Cost to Government

The economic impact of student loan programs on the federal government's budget is significant. Subsidizing loans and offering forgiveness policies come with a hefty price tag. The cost of these programs is influenced by factors such as default rates, the number of loans disbursed, and the terms of repayment.

Income-driven repayment plans and forgiveness policies can increase the program's cost to the government because they may extend the repayment term and, in the case of forgiveness, result in the government absorbing the unpaid balance. This represents a transfer of wealth from taxpayers to borrowers and may require balancing acts in federal budgeting to accommodate the long-term costs associated with these programs.

Forecasting Policy Outcomes

Forecasting the outcomes of any policy change, particularly in the complex realm of student loans, involves numerous considerations. Accurate predictions must account for borrower behavior, economic conditions, job market trends, and educational costs.

President Obama's advisors might have underestimated the appeal of the new loan terms and failed to predict the increased cost due to more students taking out larger loans and the greater utilization of loan forgiveness. These forecasting challenges highlight the importance of ongoing policy assessment and the need to adapt strategies as real-world impacts become clearer. Any discrepancy between forecasted and actual outcomes can be used to refine future policy changes, ensuring they are financially sustainable and effectively support student borrowers.