President Biden recently announced a controversial student loan forgiveness program. Rather than debate the morality of whether or not this debt should be canceled, let’s strictly focus on the potential economic implications to determine if a change in investment strategy is warranted.
There are three major components to the program, and the first is debt cancellation. Individuals earning less than $125,000 (or $250,000 for families) a year will be eligible for up to $10,000 in debt cancellation. Pell Grant recipients earning less than $125,000 (or $250,000 for families) a year are eligible for up to $20,000 in debt reduction1.
The second is extending the loan forbearance program through the end of 2022. Student loan forbearance allows a borrower to temporarily pause or reduce monthly payments. This began during the recession of 2020 to help borrowers cope with the mandatory shutdowns, and it has been extended several times since then.
The third is a new Income-Driven Repayment (IDR) plan that proposes to cap the monthly payments to 5% of the discretionary income for borrowers. It’s also covering the borrower’s unpaid monthly interest so that debt balances will not grow even when monthly payments are zero.
Furthermore, it will raise the amount excluded from the calculation of discretionary income from 150% to 225% of the poverty line. Loan balances are forgiven after 10 years of payments, instead of 20 years, for borrowers with original loan balances of $12,000 or less1.
Let’s take a moment to translate the IDR into English because there’s a lot to unpack. The poverty line for a single individual is currently $12,8802. That means the threshold for paying anything is 225% of this figure, or just under $30,000 ($12,880 x 225% = $28,980). So, if the borrower’s annual salary is below this number, the monthly payment is zero.
But let’s assume the borrower has a great job that pays $100,000/year. No matter how much is borrowed, they’re limited to paying interest based on their salary above this $30,000 threshold. Here, the borrower would pay no more than 5% of $70,000 ($100,000 - $30,000 = $70,000) each year, or $3,500 total. After twenty years, any remaining debt would disappear.
Economic impact
If this plan is implemented in its current form, the impact on the U.S. economy could be significant. The Committee for a Responsible Federal Budget is a nonpartisan, nonprofit organization committed to educating the public on issues with significant fiscal policy impact. They estimate the total cost would be anywhere between $440 billion and $600 billion over the next ten years.
Combined with this proposal, this group estimates that the federal government’s actions on student loans since the start of the COVID-19 pandemic have cost around $800 billion. Of that amount, roughly $750 billion is due to executive action and regulatory changes made by the Biden Administration3.
The Penn Wharton Budget Model (PWBM) is another highly respected, nonpartisan group. They estimate the total cost on the low end to be $605 billion over ten years, but it could quickly exceed $1 trillion due to assumed behavioral changes of both students and colleges in response to the IDR program4.
Since monthly payments are based on salary and not the amount borrowed, students have an incentive to borrow as much as possible. For example, if one college charged $50,000 and another was $250,000 but came with nicer amenities like spa treatments and nicer dorms, borrowers should pick the latter because their monthly payment wouldn’t change. After twenty years, any remaining debt would go away.
Students would also have an incentive to take out loans that exceed tuition, room, and board. These “living expenses” could pay for dinners, traveling, gambling, etc. It wouldn’t matter because the added debt is immaterial to their monthly payment, and the debt will be forgiven anyway.
Colleges will have an incentive to admit anyone with a heartbeat for any degree with zero care for future earnings potential (some argue this is already the case). And if you think college is expensive today, get ready. Since borrowers will never have to pay it back and colleges have no “skin in the game” when it comes to the success of their graduates, tuition could skyrocket.
Lastly, one must consider the impact of taking the risk out of fine arts degrees. Would this attract students who would otherwise seek degrees that are far more valuable to our workforce like engineering and applied sciences? If so, how would that impact the economy over the long run? Tangentially, what does the workforce look like if college kids no longer need jobs during the school year or over summer break to pay for their education?
The bottom line
Through a pure economic lens, the total cost combined with a perverse incentive structure makes it virtually impossible to view this program positively. But this in no way implies that action must be taken towards your investments for three reasons.
First, nothing is set in stone. This program was not passed through the traditional legislative path via Congress. Biden issued an executive order, and the Supreme Court could step in5. One of the biggest mistakes any investor can make is betting on the outcome of a government decision, so it’s best to just sit tight for now.
Second, even if it survives the courts, the economic impact probably won’t be felt for several years. If so, making rash decisions today could create needless risk (putting the cart before the horse).
Third, this is not the first time controversial legislation has been shoved down our throats, and it won’t be the last. Each time the country and our economy have endured, and there’s no evidence to suggest this time will be different.
The bottom line is that both Democrat and Republicans regularly attempt bad economic policies for reasons that are often politically motivated. But any investment decision must consider both the likelihood and the timing of when any impact – good or bad – will be felt on the economy.
Sources
3 https://www.crfb.org/blogs/new-student-debt-changes-will-cost-half-trillion-dollars
4 https://budgetmodel.wharton.upenn.edu/issues/2022/8/26/biden-student-loan-forgiveness
Disclosures
This material has been prepared for informational purposes only and should not be construed as a solicitation to effect, or attempt to effect, either transactions in securities or the rendering of personalized investment advice. This material is not intended to provide, and should not be relied on for tax, legal, investment, accounting, or other financial advice. You should consult your own tax, legal, financial, and accounting advisors before engaging in any transaction. Asset allocation and diversification do not guarantee a profit or protect against a loss. All references to potential future developments or outcomes are strictly the views and opinions of Richard W. Paul & Associates and in no way promise, guarantee, or seek to predict with any certainty what may or may not occur in various economies and investment markets. Past performance is not necessarily indicative of future performance.