Why Default Matters

Does student loan default matter? Some would argue that, from a pure dollars-and-cents perspective for society, default isn’t all that costly. In a recent interview with Higher Education Washington Inc., Diane Auer Jones, Assistant Secretary of Education, said “…(T)here is not a substantial cost-savings (with VFAs, a default prevention program) because a defaulted loan that comes to the federal government, by and large, gets paid. The federal government has the ability to collect the dollars. By and large, we actually do recapture those dollars.”

But what about the steep price paid by the defaulted student loan borrower? A side-by-side comparison shows that a student loan borrower who defaults on his obligation can pay more than $5,000 in additional interest and fees for every $10,000 borrowed. Extrapolate that out to a $40,000 to $50,000 total student loan debt load (easily done if a student attends graduate school) and the additional cost of default over the entire life of repayment equals a staggering $20,000 to $25,000—the equivalent of a new car or a down payment on a home.

The cost of default

The examples below illustrate the high cost of default. Each scenario assumes a subsidized Stafford loan with a starting principal balance of $10,000 and a 6.8% interest rate.

Borrower #1 understands the obligation and repays the loan on schedule (within 10 years), with no setbacks:

Borrower #2 is unable to start repayment as scheduled, but obtains deferments for 2 years, then begins repaying for 1 year, followed by a forbearance for 1 year, and then repays the loan without further interruption. Deferments and forbearances are the right of every federal student loan borrower to postpone payment if he/she meets certain criteria.

Borrower #3 does not start repayment as scheduled and goes straight into default (270 days, or 9 months, of non-payment). Defaulted loans are subject to additional collection costs. The scenario below assumes the ASA standard 18.5% collection cost. After 3 years, the borrower rehabilitates the loan and repays on schedule over 10 years. Rehabilitation requires the borrower to make 9, consecutive on-time payments to bring the loan out of default.

Clearly, default matters on an individual borrower level. Defaulted borrowers pay a significantly higher total cost of repayment, as well as suffer damage to their credit that can affect their future buying power and even their ability to secure employment.

And society pays a price, too. Even though, as the Department of Education points out, the federal government has the ability to recapture dollars directly from the defaulted borrower, so that taxpayers don’t bear the burden, default still impacts our nation’s budget. If defaults outpace the number estimated in the Department’s annual budget, budget dollars must be diverted from other federal programs to make up the difference.

Align student loan policy with nation’s values

Our federal student aid programs were put in place to fulfill a public purpose mission: to ensure all students, regardless of income level, have access and choice in higher education. The student, as the primary beneficiary of federal aid, is the ultimate customer in the federal student loan process.

So when our nation sets policy for the federal student loan program, it must take into consideration the true, harmful cost of default for the borrower. College students and families deserve policies that fully support the prevention of repayment problems. Specifically, innovative programs that focus federal student loan guarantors on default prevention, called Voluntary Flexible Agreements, should be granted permanence in the HEA.

Recognizing the societal need to teach student loan borrowers debt management and financial literacy, Congress enacted VFAs in the last HEA reauthorization. VFAs are agreements between a FFELP guarantor and the Department of Education that transition the guarantor financing model from one incented by default collection to proactive delinquency and default prevention. American Student Assistance was one of the first generation of guarantors to spearhead the VFA movement, and in just the first 6 years of operating under its VFA, ASA has saved thousands of borrowers from the higher cost of default and achieved the lowest default rate in the nation.

VFAs have more than proven their worth. The experimental VFA programs to date have shown time and again that guarantors can impact a borrower’s repayment behavior through greater communication, outreach and the ability to revisit federal rules and regulations that have lost relevance for the 21st century borrower. Simply put, VFAs work for our most important customer, the borrower. Now it’s time to make sure the VFA model becomes a permanent part of our nation’s higher education policy—for the good of student loan borrowers everywhere.

What do you think—should default matter in our federal aid policies?

Posted by Shelley Saunders on December 03, 2007 at 10:34 AM EST

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