10 years ago, when Nuno Clara was studying ways of making mortgages less vulnerable to default, he wondered why student debt wasn’t also being examined. He says student debt was growing exponentially at that time.
“Just looking at people’s balance sheets, student debt could be the next crisis,” he thought.
Clara decided to research the issue and discovered reformulations of debt repayment contracts could offer solutions.
Clara, an assistant professor of finance at Duke University’s Fuqua School of Business, with his colleagues Michael Boutros of the Bank of Canada and Francisco Gomes of London Business School, explain their findings in a working paper titled: “Borrow now, pay even later: A quantitative analysis of student debt payment plans.”
Clara says the researchers found that allowing borrowers to postpone the repayment of their debt would boost overall economic health, without forgiving the debt.
The results surprised Clara.
“I thought there was no way our policies could be better than just forgiving student debt,” Clara said, referring to the debt-forgiveness plan advanced by U.S. President Joe Biden’s administration.
Clara said research showed a 10-year deferral of the debt repayment plan would yield the same benefits as the outright forgiveness of the debt, without an impact on the fiscal side. The authors measured the impact of their plan in terms of borrowers’ lifetime consumption and savings.
The researchers say a deferral would also substantially decrease default on student loans, because people could repay them later in life when they can more easily afford them.
The stakes are big, Clara said: In the U.S., student debt is 7% of the Gross Domestic Product and represents the second largest component of personal debt, behind mortgages. According to the paper, the average student-borrower leaves college with a debt of $37,000, up from $18,000 in 2008.
Clara said such debt early on in an individual’s professional life puts a strain on both basic expenses and long-lasting investments, undermining lifetime accumulation of wealth.
“If I have this debt on my balance sheet, that debt affects whether I can get a loan for a car, or a mortgage,” he said.
Clara said student debt also reduces available income at a time when each dollar is especially important.
“When I'm young and I don't have a lot of income and savings, every extra dollar is very, very valuable,” Clara said. “Later on, when my income has probably gone up and I have some savings, that extra dollar is not worth that much anymore.”
Clara believes postponing debt repayment after 10 years would allow people to use that extra cash to buy a car, a house, start a family, save for rainy days, and potentially allow more people to participate in the stock market or more easily search for better paying jobs.
Clara and his colleagues' policy proposal outlines two alternative repayment contracts. In one case, the borrower would only pay interest for 10 years, and only start repaying the principal (the initial amount of debt) after 10 years. In the second option, the borrower wouldn’t pay anything at all for 10 years. In either case, Clara said, the federal government would reprice the debt accordingly (to cover for the delayed repayment), so that the proposed alternatives would not affect the federal budget.
Currently, the vast majority of student loans are issued by the U.S. Federal Government, Clara said. Borrowers can either choose the standard repayment plan (where “if you make the monthly payments, after 10 years you are debt free,” he said), or alternatively choose an income-driven repayment plan, where borrowers only pay a fraction of their income every month up to 25 years (after which, if the debt hasn’t been fully paid, it gets discharged).
“Our model shows that forgiving between $11,000 to $17,000, the same range as in the loan-forgiveness plan, yields the same gains for students as our payment deferral plans,” Clara said.
The authors write that their estimates are actually conservative, since they don’t factor in the negative economic effects of taxes or spending cuts necessary to finance the federal debt-forgiveness policy.
“Our model delivers the same gains at no fiscal cost,” he said. “It seems like a free lunch.”