ICL is Different from Traditional Student Loans

Representative Petri has introduced a new bill that would replace our mess of student loan repayment programs with a new one based on the principles of income contingent lending (ICL). The commentary to date is quite confused, which is understandable since there are a lot of different versions of ICL. There are the international versions (see the appendix of this Education Sector report for a good summary of these), domestic versions of ICL (IBR and ICR), and proposed ICL programs (e.g. Representative Petri’s and my own proposal).

We’ll be blogging about the pros and cons of the various types of ICL in the new year, but for now, a lot of confusion can be cleared up by just noting the biggest difference between traditional and ICL loans – how repayment is determined.

The structure of traditional student loans was essentially copied and pasted from the world of commerce, which is why traditional student loans look a lot like a mortgage. The borrower agrees to repay the lender a predetermined amount each month for a set amount of time. For example, if I graduate with $20,000 in traditional student loans, I’ll have to pay $235 a month for 10 years to pay off the loan.

But as the Carnegie Commission wrote almost 40 years ago, “traditional loan concepts, borrowed from the world of commerce and industry… are not equally appropriate to investment in [education].” Unfortunately, this did not stop policymakers from applying traditional loan concepts to student lending, leading to a series of problems that each required their own Band-Aid to (try to) remedy.

The first Band-Aid was non-dischargability of student loans in bankruptcy court. If you don’t repay your mortgage, the bank can take your house, but if you don’t repay your student loan, the lender cannot repossess your education. This lack of collateral for educational loans meant that students could (and a few did) declare bankruptcy right after graduation to get their student loans wiped out, even if they had a high-paying job that enabled them to repay. Making student loans non-dischargeable addressed this problem.

However, making student loans non-dischargeable exacerbated another problem, which was that setbacks (such as a spell of unemployment – not all that uncommon among new graduates) would result in huge numbers of students defaulting on their loans. The second Band-Aid addressed this problem by introducing grace periods, forbearance, and deferment, all of which helped enable students to weather setbacks without defaulting on their student loans.

But as college prices continued to climb (partly fueled by poorly designed student loan programs), students started accumulating more and more debt, meaning that even some students with relatively high paying jobs were facing difficulty repaying their student loans. Hence the third Band-Aid: loan forgiveness programs.

While the implementation of these three Band-Aids often left a lot to be desired, the underlying rationale is at least understandable… as long as we are restricted to using traditional loan concepts for student lending.

But once we allow for income contingent lending, these rationales no longer apply. With an income contingent loan, the payment is equal to a certain amount of income (e.g. 10% of income above the poverty line), meaning that under ICL, the payment amount and the repayment time frame are not laid out in advance. By tying payments to current income, students will always be able to afford their loan payments. For example, if you have ICL student loans and lose your job, your payments automatically drop to zero because your earnings dropped to zero.

This means that objections to ICL on the grounds that it lacks forbearance, deferments and forgiveness  (e.g. Lauren Asher of the Institute for College Access & Success) are misplaced. None of the Band-Aids that are necessary for traditional student loans are necessary for ICL student loans. Non-dischargablity, grace periods, forbearance, deferments and forgiveness address a problem – unaffordable student loan payments – that simply does not exist under ICL. Under ICL payments automatically adjust to current income, so payments are never unaffordable.