Choppy Waters: How the Student Loan System Reverses Progress for Previously Defaulted Borrowers

Yesterday, the Consumer Financial Protection Bureau (CFPB) reported new data on the nearly one-third of all federal student loan borrowers who have previously defaulted on their debt and who default again within two years of returning to good standing. It’s bad news for the most promising group of borrowers in default. In order to redefault, many have already navigated a complex loan rehabilitation process. Clearly willing and able to right their debts, many of these borrowers have proven that they can make nine on-time payments, often in amounts that exceed the minimum they will have to pay once their loan is restored. But despite their best efforts, strong headwinds have inevitably pushed many of these borrowers back off course.

Part of the reason so many borrowers redefault is that they fail to enroll in important federal protections. The CFPB finds that only 10 percent of borrowers who default and then manage to rehabilitate their loans subsequently enter an income-driven repayment (IDR) plan within nine months of being back in good standing. Income-driven repayment plans, which tether a borrower’s payment to an affordable percentage of his income, is the best way to avoid choppy waters in the future. Tellingly, for the overwhelming majority of high-risk borrowers who fail to access these protections after restoring their debt, nearly half proceed to redefault within three years--five times the likelihood that someone in an IDR plan redefaults over the same period. This is especially troubling given that many of the highest-risk borrowers have incomes low enough that they would qualify for zero-dollar “payments” under IDR. During the rehabilitation process, these borrowers would have been required to pay more, at least five dollars per month. 

There are likely two main reasons that so few borrowers take advantage of IDR once they have restored their debt to good standing. The first involves a series of unnecessary and redundant obstacles through which a borrower must pass in order to take advantage of these lower payments. The second stems from perverse financial incentives that reward debt collectors for steering previously defaulted borrowers into a confusing course that does not set them up for long-term success.

After a previously defaulted borrower completes loan rehabilitation, a process in which monthly payments are calculated very similarly to an IDR plan (based on his income and expenses) but which don’t count towards his eventual loan forgiveness, he is automatically placed back into the standard 10-year plan. In other words, after nine months of making affordable payments, a borrower who has already completed the necessary steps to certify his income must again request to enroll in IDR after the rehabilitation process concludes--when his loans are transferred back from the debt collector to a servicer. If he fails to refile the paperwork once he resumes good standing with his servicer, a borrower’s monthly payments return to a portion of the total amount he owes, not  a percentage of what he can realistically afford to pay.

If a borrower has successfully completed the terms of rehabilitation, the debt collection agency presumably already has his income on file, since it uses this information to calculate his monthly payment during rehabilitation. This income information could theoretically be shared seamlessly with a borrower’s servicer once he is transferred out of collections, porting over the payment calculation instead of putting the onus back on the borrower to track down the paperwork all over again. Furthermore, a previously defaulted borrower has made it clear that he is willing to pay when he can afford the monthly amount calculated under a rehabilitation scheme that is very similar to IDR.  But for many, an abrupt jump in the monthly payment owed after completing rehabilitation can come as enough of a shock to derail the important progress of the past year. So why not simply make IDR an automatic step in the process?

For some previously defaulted borrowers, IDR is actually already a required and entwined part of restoring a defaulted loan -- just not for those who use rehabilitation to get there. While the most common way for a borrower to escape default would be to rehabilitate his loan through the aforementioned steps, he can instead consolidate a loan. For those who use consolidation to get their debts back in good standing, they take out what is effectively a completely new loan from the federal government, which pays off the one(s) in default. Previously defaulted borrowers who consolidate are also mandated to enroll in IDR when they take out this new loan. As such, consolidation not only eliminates the need for a nine-month limbo period and more quickly gets a borrower back on track; but by combining the consolidation process with IDR enrollment, it also seems to have better long-term outcomes for high-risk borrowers.

Unfortunately, strong financial disincentives for collection agencies may limit the number of high-risk borrowers who pursue the consolidation route. This is because the federal government pays student debt collection agencies about $1,710 for restoring a defaulted loan through rehabilitation. On the other hand, for helping a borrower consolidate a loan to push free from default, collectors typically get to keep only about 3 percent of the total volume that they return. Since two-thirds of borrowers in default have less than $10,000 in debt, this leads to lower financial returns for debt collectors that encourage students to consolidate their loan, compared with the flat fee they can claim for getting a borrower through rehabilitation. Unsurprisingly, this payment structure is reflected in borrowers’ outcomes: Less than a third of of the total loan volume that is restored from default goes through the consolidation process.

Making IDR automatic for high-risk borrowers who have already run aground is a relatively easy fix that could prevent repeated default, but it is only part of the solution. While those who consolidate their loans instead of using rehabilitation seem to have better outcomes, a non-negligible 20 percent of previously defaulted borrowers who used consolidation enter default again within two years despite the initial protections offered by IDR. While that is no doubt exacerbated by the annual income recertification requirements and other logistical hurdles placed on borrowers, Congress and the Department of Education must also better balance priorities and incentives for the companies tasked with helping borrowers maneuver the student loan system before and after they encounter trouble.