The Money Commando

Unintended side effects – Federal loan forgiveness

TheMoneyCommando

One of the main reasons I have such a strong libertarian bent is because I’ve seen so many unintended side-effects from various government programs. It’s almost impossible to create a policy, tax break, or government program that doesn’t affect the behavior of the free market.

That isn’t to say that these policies/programs are necessarily bad or harmful. In fact, I agree with the stated goals of many of them. Unfortunately, as we’ll see, these policies/programs always have unintended side effects that sometimes cause problems that are bigger than the problem that are designed to solve.

This is the fourth installation in a series of articles about the unintended (usually negative) side effects of government policies (federal, state, or local).

In Part 1 of this series we looked at the mortgage interest tax deduction.

In Part 2 of this series we looked at student loans.

In Part 3 of this series we looked at California’s Prop 12.

In Part 4 we are going to talk about the Federal loan forgiveness program.

Federal loan forgiveness

The stated goals

The goal of the federal loan forgiveness program is simple (and laudable) – to encourage recent college graduates to enter into public service professions (teaching, Peace Corp, Americorp, etc.)

This is actually breaks down into two separate goals:

Explanation of programs

Federal Loan forgiveness consists of a 2 different programs.

Public Service Loan Forgiveness – in order to qualify for this program you must work for at least 10 years in a public service job, which includes firefighting, teaching, military, government, and nursing. 

Eligibility in the Public Service Loan Forgiveness program depends on who your employer is, not on what you’re actually doing. Qualifying employers include:

If you meet all of the eligibility requirements listed above, then after 120 loan payments your entire remaining qualifying Federal loan balance will be forgiven.

There’s one big problem – most student loans have a 10-year repayment schedule. The vast majoring of borrowers won’t benefit from this program. The only way to benefit is if you actually have a loan balance after 10 years.

And the only way to have a student loan balance after 10 years is to pay less than the normally scheduled loan payment amounts. However, you can’t qualify if your loan is in default or if you are behind on loan payments. The only way to still have a loan balance is if you’ve negotiated a special payment plan, such as an Income Driven Payment Plan.

Student Loan Forgiveness for Teachers – teachers can qualify for the Public Service Loan Forgiveness program, but there is a separate program for teachers that is potentially more generous.

To qualify for the program you must teach for 5 consecutive years at a qualifying low-income elementary or secondary school. Note the “low-income” requirement. This program is not available to teachers at all schools, only teachers at low-income schools.

The amount of loan forgiveness depends on the subject you teach. Secondary math, science, and special education teachers can get up to $17,500 forgiven. Other secondary teachers and any elementary school teacher can get up to $5,000 forgiven.

Unintended side effects

Government programs ALWAYS have unintended side-effects, and the Federal loan forgiveness plan is no exception. The unintended side effects include:

Encourages debt

Ultimately, the biggest issue with the program is that it only provides a benefit to people who have student loans. If you don’t have any loans then you can’t benefit from the program.

If you are a college student who is planning on becoming a teacher or firefighter or work for the government, the rational thing to do is to maximize your student loans. After all, the higher the loan balance the higher the potential payoff when the loan is forgiven.

Since you can’t benefit from loan forgiveness if you don’t have debt, the rational thing to do is to borrow for college, even if you can afford to pay right now. If you plan to use the Public Service Loan Forgiveness plan you should maximize debt, as ALL debt is forgiven after 120 payments.

If you plan to use the Student Loan Forgiveness for Teachers then you’d want to do some simple math to determine the optimal amount of student debt to take on. If you plan to be a math/science teacher at the secondary level then you’ll want to ensure you have at least $17,500 in debt remaining after 5 years so you can maximize your benefit. 

It’s clearly not a good idea to encourage people to go into debt.

Provides a higher income to people with debt

The corollary of point 1 is that beneficiaries of the Federal loan forgiveness programs actually have higher income than those without debt.

Let’s say you have two recent college graduates who decide to become math teachers. Both are making $50,000/year. One has $30,000 in student debt. One has no debt.

At the end of 5 years the teacher with the debt will essentially get a $17,500 bonus because the government will forgive that much of their loan balance. That’s the equivalent of making an additional $3,500/year tax-free. Assuming a 22% tax bracket, that’s the equivalent of $4,487 in additional earned income. 

Does it make sense for one teacher to be making 9% more money just because they took out student loans in college?

Encourages people to pay down their debt as slowly as possible

Both of the programs described above only have value to the borrower if the borrow still has student loan debt remaining after 5 years or 10 years, depending on the program.

This discourages borrowers from paying their loans back as quickly as they can. If you’re a teacher and have the ability to pay back your loans at an accelerated schedule, you should instead save your money and draw out your payments as long as possible.

Does it make sense to incentivize people to not pay down their debts?

Keeps people in public service jobs they might not like

This is the perhaps the biggest problem – these programs provide no payoff until you hit the 5-year or 10-year cliff (depending on the program). If you work as a teacher for 4 years and 11 months and then quit, you get nothing. There’s no pro-rated payout. 

If a teacher has been working 3 years they are strongly incentivized to continue teaching for at least 2 more years to get the loan forgiveness. This is, of course, the whole point of the program – to encourage people to become teachers and stay teachers.

The other requirement for teachers is that you must work at a low-income school. If you grew up in a middle class neighborhood and dream of teaching in your community…to bad. You can’t teach at your local school and qualify for the program.

But the problem is that incentivizing people to stay in a job, even if they are miserable, doesn’t seem like a good idea for anybody. The teacher will be unhappy (and probably perform poorly), the students will get a worse educational experience, and the government ends up forgiving a loan balance for an unhappy, poorly performing teacher.

Possible fixes

The solutions are pretty obvious. First, get rid of these programs and instead:

Make it less expensive to go to college

This seems obvious – if you want more teachers, make it cheaper for people to become teachers. Subsidize degrees in education. Make teaching credential programs FREE. Provide placement programs and guidance to help people in other industries who are considering changing careers to become teachers and public servants.

Note that this does NOT mean providing more loans. It doesn’t mean providing loans at lower cost. It doesn’t mean providing loan forgiveness.

It means finding a way to make college cheap enough so that everybody who wants to get a secondary education can do so. Other countries manage to do this today. In fact, plenty of other developed, westernized democracies manage to make college FREE. This list includes Denmark, Germany, Finland, Greece, Ireland, and Norway. In places like France, Austria, and Switzerland the tuition is so cheap that it’s almost free.

If students don’t need to take loans to go to college then loan forgiveness won’t be necessary.

Provide higher pay for teachers and public servants

Teachers and public servants are criminally underpaid. Make it a priority to increase the compensation for these professions. If teachers and cops and Peace Corp employees are paid enough they’ll be able to pay any loans themselves. And with no incentive to get loans in the first place, perhaps students will instead be incentivized to work their way through school rather than take on enormous student debt.

Conclusion

The underlying problem is that governments try to engineer behavior through the tax breaks and other financial incentives. Sometimes these incentives make a lot of sense. For example, providing tax breaks (child tax credits) for having children and then providing those children with a free education makes sense, because those children will be running the country when the current generation is retired. Making sure the children are capable of keeping the economy running is in the best interest of the current generation.

But in this case, the incentives create problems. Encouraging future teachers and public servants to take on debt and then discouraging them from paying the debt doesn’t seem like a good idea.