A modified version of this post originally appeared on Fortune.com
Over seven million people are in default on more than $100 billion in federal student loans, and that number is up by half a million people from a year ago. To solve this crisis, members of Congress like Senator Elizabeth Warren have proposed cutting interest rates, and paying for it with a tax increase. While you can’t beat the Robin Hood appeal, the interest rate cut would only decrease the average monthly payment of someone facing default by about $16, which is hardly a cure-all.
Instead of lowering interest rates, we should just eliminate them altogether, and the best part is that its replacement requires no new taxpayer money.
Interest rates on student loans do cause a lot of confusion and anxiety among student borrowers–it’s a popular political issue for a reason–but instead of lowering interest rates, we should just eliminate them altogether, and the best part is that its replacement requires no new taxpayer money.
Of course, for the government to offer zero-interest-rate loans at no new cost to taxpayers, something else has to give. The government can pay for its interest rate elimination by adding the cost of lending and servicing the loan into the original amount borrowed, which is known as an origination fee—the student would also be able to borrow the amount needed to cover the fee.
Origination fees are normally viewed with suspicion and seen as a hidden fee, but student loans could be the exception. Compared to charging interest, an origination fee would make the loans more transparent, cause less anxiety, and make the loan program better targeted to helping low-income borrowers.
Student loans accrue interest while students are in school and not paying, which means their loan balance upon exiting school is not what they remembered borrowing. When New America recently conducted focus groups with struggling student loan borrowers, this issue frequently elicited feelings of being deceived.
“You take out these loans and you don’t realize that this interest is building up as you’re going to school,” explained Miriam, a first-generation college graduate of a large state university in the Southwest and whose first name has been modified to protect her identity. “When I finished, this big amount appeared, and I thought, ‘Holy crap, what happened? I didn’t take out that much.’”
Interest rates are attached to traditional loans because they compensate for inflation and for the risks and costs associated with lending money to a borrower. But interest isn’t the only way to account for those added costs. An origination fee on a student loan would allow Miriam to know from the time she took out the loan exactly how much she owed. She would still pay the same amount in total—it would just be transparent and upfront, with no surprises upon exiting school.
Let’s compare the two approaches. Say Miriam borrows $10,000 at an interest rate of 5 percent over the four years she went to school, like she would in the current system. Assuming she makes on-time monthly payments for 10 years after graduating, she will have paid around $14,000 in total. So why not just make her loan balance $14,000 from the start ($10,000 for the loan and a $4,000 fee), and not charge any interest?
The origination fee approach is even more appealing when paired with a plan where borrowers pay back their loans based on a small percentage of their income. This “income-based repayment” plan, an existing option for borrowers with federal loans, and one many lawmakers propose making the automatic option for new borrowers, actually makes an origination-fee loan far more progressive than the current interest-rate loan.
In a system where payments are based on earnings, low-income borrowers make low payments and take a long time to pay back. With interest-rate loans, interest keeps accruing, which means low-income borrowers owe more over time. Right now, the program is designed to forgive some or all of that interest, but only after 20 years of income-based payments. That’s financially beneficial, but the thought of making payments on a loan balance that doesn’t budge for 20 years is daunting. With an origination fee loan, not only would the loan never get bigger, but making lower payments over a longer period of time is actually an advantage—in this case, time really is money.
If Miriam, the first-generation graduate, pays back the $14,000 she owes over 10 years with no interest, the total amount paid is equivalent to paying off a $10,000 loan with 5 percent interest that begins accruing while in school. If she pays it all back in the first year after graduating, it’s closer to 9 percent interest. If she took 20 years to pay it off, it would be 2 percent. She pays back $14,000 in each case, but the longer it takes to repay, the cheaper the loan becomes. And under an income-based repayment system, borrowers making the least amount of money pay for the longest amount of time.
That’s a huge advantage compared to the current interest-rate loan from the perspective of many borrowers, including Dylan, who recently dropped out of a technical college in Arizona and says that he thinks income-based repayment with interest-rate loans “is pointless in a way, because you’re giving away money when you’re paying it back.” His balance keeps getting bigger even as he’s giving up money he could otherwise use for something else.
“If I actually saw the balance go down, I’d be way more motivated to pay it on time, but…the balance keeps going up,” says Melissa, who graduated with a bachelor’s degree from a Baptist college in Georgia and said her loans feel “never-ending, and they keep adding interest no matter how much you pay.” With only an origination fee, every payment Melissa makes would lower her overall balance.
Replacing interest rates with origination fees may seem radical, but it has the potential to make the student loan process far more transparent, progressive, and palatable for millions of borrowers in repayment. The answer to the problems around student loan interest isn’t to slightly lower the rates, but instead to rethink how a loan ought to work altogether.