What If Student Loan Payments Were Tied to Your Paycheck?

Quick: After home mortgages, what’s the next-largest liability for American households? It’s student loan debt, which totals a staggering $1.8 trillion.

“Over the past 10 to 15 years, there’s been massive growth in the amount of student debt,” says Tim de Silva, an assistant professor of finance at Stanford Graduate School of Business. “Part of that is because college has become more expensive.”

While student loans make higher education more accessible, paying them off can be difficult for people with low incomes. About 25% of borrowers are expected to default within five years. One way to ease the burden is income-contingent repayment plans, which adjust borrowers’ payments based on their earnings.

“College is a large but risky investment that may or may not pay off,” de Silva says. Income-contingent payment plans provide borrowers with type of risk protection that he likens to the equity-based financing available to corporations. “Early-stage businesses often finance their risky projects using equity, which provides a form of insurance. It makes sense that we may want the same thing for education, where repayment is based on your income: If college turns out to pay off for you and you earn a high income, you pay more, but if it doesn’t pan out, you have a lower income and hence pay less.”

While this approach has benefits relative to requiring all borrowers to make fixed payments regardless of their post-graduation income, it can incentivize borrowers to work less or take lower-paying jobs. This moral hazard reduces the labor supply and imposes costs on the government in the form of lower loan repayments and lower tax revenues.

To better understand the trade-offs that come with income-based student loan repayment, de Silva studied Australia’s government-sponsored student loan program. “They were the innovators, the first to introduce income-contingent loans back in the late 1980s,” he says. As part of his doctoral dissertation at MIT, de Silva used Australian data to compare income-based student loan repayment with fixed-payment systems.

The results, published in The Quarterly Journal of Economics, revealed that while income-based repayment does cause borrowers to earn less, these costs are more than offset by the benefits of providing insurance to low-income borrowers through repayment reductions. “There’s an economic cost and benefit, but my estimates imply that the benefits are likely to outweigh the costs,” de Silva says.

Lending in a Land Down Under

Analyzing data for the entire population of over 4 million student-loan borrowers in Australia, de Silva found that borrowers, especially those with less liquidity, more flexible working hours, and large debt burdens, reduce their labor supply to lower their payments. On average, borrowers are willing to work one to two fewer weeks per year to avoid making any repayments.

However, on the benefit side, the value of the insurance to low-income borrowers far outweighs these costs. De Silva estimates that moving from the fixed payment policy that has been the default in the U.S. to an income-based repayment policy increases households’ average lifetime consumption of goods and services by nearly 1.5%. “An increase of almost 1.5% is pretty sizable,” he says. In comparison, if all student loans were forgiven, the expected increase in consumption would be less than twice that. “The research shows that a properly designed income-contingent loan gets you over half of the way to full forgiveness, while still ensuring that borrowers repay the same amount on average.”

In short, income-contingent repayment plans have a net-positive effect, as de Silva explains: “They do distort household labor supply in a non-trivial way, but the value of the insurance benefit they provide is much larger.”

What do the findings from Down Under mean for the U.S.? “Any time you extract from one country to another, you need to be very careful,” de Silva says. “But there are lessons that apply to the U.S., where there has been a growing push to introduce income-contingent repayment plans.”

Income-contingent plans in the U.S. have been complicated and difficult to access. College students must navigate a range of plans that may change due to legal challenges or political winds. (President Joe Biden’s income-driven repayment plan is currently tied up in court, and the Trump administration has replaced it with its own plan.) “It’s a mess,” de Silva says. “It’s very unclear what’s going to happen under the current administration. A first-order issue is finding ways to improve knowledge and reduce the regulatory burden of income-contingent loans.

The Biden administration also wrote off $184 billion in student loans. That’s not the ideal solution, de Silva argues. “My research shows that forgiving student debt is not a very efficient policy,” he says. “Full forgiveness leads to a very large cost to taxpayers, while also targeting forgiveness in an ineffective way.”

Likewise, income-based repayment plans that forgive balances after a fixed number of years haven’t been effective, in de Silva’s view. “Adding forgiveness to income-based repayment creates an incentive for people to lower their incomes when they’re close to the point where they wouldn’t have to repay the loan regardless. Income-contingent loans do a lot of good things without needing second-best tools like forgiveness.”