Behavioral Biases and the Design of Student Loan Repayment Schemes

Awarded Scholars:
Lesley J. Turner, University of Maryland
Kathleen Abraham, University of Maryland
Emel Filiz-Ozbay, University of Maryland
Erkut Ozbay, University of Maryland
Project Date:
Sep 2015
Award Amount:
$99,959
Project Programs:
Behavioral Economics

Over the last decade, student loan debt, delinquencies and defaults have increased considerably. According to Federal Reserve data, total student loan debt climbed from $364 billion in 2004 to almost $1.2 trillion in 2014. During this decade, the percentage of borrowers in repayment and over 90 days delinquent rose from 20% to nearly a third. These trends have stimulated various policy proposals, including income-based repayment (IBR) plans that would link loan payments to borrowers’ earnings, or "human capital contracts" (HCC) that would allow students to pledge a set fraction of post-college earnings for a specified period in exchange for tuition.

Professor Lesley J. Turner and her colleagues note that such plans should be most attractive to borrowers who anticipate persistently low income or uncertain future earnings. However, if those who expect to have low earnings adversely select into income-driven plans, it could potentially undermine the financial viability of such schemes. One option might be to require all borrowers to participate in income-driven repayment ("forced pooling") which would eliminate adverse selection into plan participation. In this case, however, forced pooling could potentially exacerbate distortions to borrowers’ in-school or labor market efforts (borrowers may be more likely to choose lower-paying majors or jobs, work fewer hours, or withdraw from the labor market altogether). How then, does one ensure sufficiently broad participation in income-driven plans to make them fiscally sustainable, but minimize distortions to work incentives for borrowers in repayment?

The investigators will examine several questions regarding students’ initial choices in regard to loan repayment. What is the relationship between the level and variance of expected earnings and students’ preferences for enrollment in an IBR scheme relative to a standard repayment plan? Does this relationship vary with the amount borrowed and the percentage of income borrowers must repay under the alternative plan? And does the relationship between earnings and preferences vary with the framing of the income-driven scheme? They will also examine the role of behavioral factors in decisions following plan selection and entry into repayment. They ask, for example: is borrower effort and repayment affected when a student voluntarily chooses—rather than being assigned to—an income-driven repayment, and how? Further, does the salience of "forced pooling" affect differences in effort and repayment under an income-driven plan that is voluntarily chosen versus involuntarily assigned?

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