Rather than getting them back on track, the most popular tool for getting out of default is instead derailing borrowers. For the more than 8 million people who are in default, the most common path back to active repayment is loan rehabilitation. This one-time only option resolves the default and returns borrowers to regular servicing after they make nine on-time monthly payments. The theory is that rehabilitation creates a habit of repaying debt monthly, preventing re-default in the future. However, troubling new data suggest that rehabilitation does not guarantee positive outcomes for defaulted borrowers.
On Tuesday, the Consumer Financial Protection Bureau (CFPB) released an update to its 2016 annual report from the Student Loan Ombudsman. Using data from five federal loan servicers that, together, manage the accounts of more than 20 million borrowers, the CFPB studied how borrowers who rehabilitated their defaulted loans fared when they re-entered a typical payment scheme. The outcomes were not good. Forty percent of those borrowers re-defaulted within three years and more than 75 percent did so without paying a single bill.
The CFPB report shows how easily borrowers can get derailed when their loans change status. The federal government doesn’t have a streamlined process for keeping borrowers in similar repayment plans, instead forcing borrowers to start at square one. And even if these problems got fixed, proposed reforms don’t address a lingering problem: Our solutions for helping borrowers stay out of default are ill-constructed for the low debt levels of the most at-risk students.
Rehabilitated borrowers are not using income-driven repayment plans
While the exact reason why rehabilitated borrowers default again is not clear, one thing the CFPB data show is that re-defaulters are not using income-driven repayment (IDR) plans that can lower, if not outright eliminate, monthly payments. According to the CFPB, about 80 percent of rehabilitated borrowers would qualify for zero dollar monthly payments in an IDR plan. However, the CFPB found that IDR enrollment rates are astonishingly low: Less than 10 percent of borrowers in their sample were making payments under IDR within 9 months of re-entering repayment. Those who did not enroll in an IDR plan were five times more likely to re-default and 45 percent defaulted within three years. In contrast, less than 10 percent of borrowers who rehabilitated and used IDR defaulted within the same timeframe.
Part of the problem is that borrowers face almost no consistency when they’re transferred from rehabilitation to default. Payments in rehabilitation are initially set at 15 percent of the borrower’s discretionary income—similar to IDR plans, most of which offer payments at 10 percent of discretionary income. When borrowers complete rehabilitation and are transferred to regular servicing, they could be in for a shock: Their payments could skyrocket due to being placed into a standard repayment plan. The borrower would then have to go through the hassle of reapplying for an IDR plan, a process similar to what they already experienced when they began the rehabilitation process.
Ironically, the CFPB data show that borrowers who take a faster path out of default than rehabilitation appear to be doing better repaying their loans. Instead of making scheduled payments to rehabilitate, these borrowers consolidated their loans, paying off their defaulted debts with a new loan that is in active repayment. The CFPB found that borrowers who consolidated their defaulted loans had better results than their peers who rehabilitated, with about 20 percent—compared to 30 percent—defaulting within two years. One reason why the consolidation numbers are better? Borrowers who consolidate to get out of default typically enroll in an IDR plan. While the consolidation default rate is still not great— especially considering the average three-year default rate for all borrowers is 11.3 percent—it does offer some evidence that getting borrowers into IDR before they go back into repayment may help prevent default.
Staying in IDR is also a problem
While getting borrowers coming out of default into an IDR plan may help fix initial problems, long-term challenges remain. A major one appears to be recertification, a process where borrowers must supply income information to their servicer each year to stay on the IDR plan. If they fail to do this, borrowers get kicked back into a standard plan and their payments skyrocket—not only because their payments are no longer tied to income but also because borrowers become immediately responsible for interest that accrued while they were enrolled in the IDR plan.
Recertification seems to be a stumbling block for the borrowers in the CFPB’s study: Although 95 percent of borrowers who used consolidation to get out of default (and, therefore, were initially enrolled in an IDR plan) were in a positive repayment status after 12 months, 20 percent defaulted after 24 months and 30 percent defaulted after three years. Since we know recertification is an issue for all borrowers, we should expect the results to be even worse for more vulnerable ones.
The hole in the repayment safety net: Small-balance borrowers
Unfortunately, fixing IDR enrollment and recertification issues will still leave many defaulters in a tough spot. That’s because the low debt balances many defaulters hold can undermine IDR’s usefulness. Most borrowers who default owe less than $5,000, which makes IDR a challenge in two ways. First, their lower balances can leave them stuck between not qualifying for IDR because of their income but being unable to afford the $50 minimum payment on the standard plan required by federal regulations. Instead of getting a 10-year repayment term like their higher-balance peers, low-balance borrowers are instead faced with a monthly payment that shortens their time in repayment while charging them an amount that may be unaffordable.
Consider a borrower with a debt balance of $3,500 and an income of $25,000. This person would not be eligible for the Pay As You Earn (PAYE) or the Income-Based Repayment (IBR) options. They would owe a higher monthly payment under Revised Pay As You Earn (REPAYE) than they would under the standard 10-year fixed payment plan. The only income-based option that would provide a lower monthly payment would be Income-Contingent Repayment (ICR), but the borrower would be in repayment for more than 19 years—a ludicrous amount of time for such low debt. Most likely, this person would get stuck making the minimum $50 payment under a standard plan. They may be unable to afford this amount but are required to pay it due to the $50 mandatory minimum payment. If the minimum payment cap was removed, they would instead owe a more affordable $37 per month, a decrease of 26 percent.
Second, low-balance borrowers who do get a payment break on IDR could end up on these plans for an unreasonably long period of time. In the example above, the borrower ends up in ICR for nearly 20 years. But if that borrower made $15,000 per year, she would pay zero dollars per month under most IDR options. However, due to the interest accruing on her loans during that time, her repayment period would be extended to a minimum of 20 years, and she’d have paid at least 1.3 times the amount of her loan by the end of this period. That’s a long time and a lot of money spent on such a small amount of debt.
Repayment must adapt for low-balance borrowers
More than 1 million borrowers defaulted in 2016. It is likely that more than 350,000 of those defaulters held less than $5,000 in debt. Default ruins borrowers’ credit and restricts their access to federal student aid, essentially barring them from re-enrolling in college and improving their economic situations.
The CFPB report clearly shows that both the repayment process and options for defaulters—particularly low-balance ones—need substantial reform. To start, the $50 minimum payment under the standard plan should be removed. This would make the automatic option for low-balance borrowers more affordable, and those who could afford to pay more could pay more if they chose to do so.
Changes must also be made to IDR. Forgiveness terms should be reconfigured for low-income, low-balance borrowers so that they are not staring down a repayment period of 20 to 25 years while making minimal monthly payments. Borrowers’ repayment options can also be simplified, consolidated into one or two IDR plans and making it easier to use the alternative repayment plan option that servicers can offer borrowers whose finances do not work with the available options. For those who do opt for an IDR plan, annual income certification should happen automatically.
For too long, we’ve asked student loan borrowers to adapt to the repayment system. It’s time the options for borrowers better reflect their needs and situations.
Colleen Campbell is the associate director on the Postsecondary Education Policy team at the Center for American Progress.