Who is going to pay the bill for the student loan forgiveness program?

An analytical approach to student loan structure.

As we have entered October, the new academic year begins, for all universities in the world. Other universities may have started classes earlier, others later, but we are now in the new academic semester. In particular, some children make the transition from high school to tertiary education, choosing the university they will attend, to be trained in the field they want to pursue. These new students, when enrolling in some countries of the world, are faced with a well-known obligation, the payment of tuition fees. It is the first major problem related to their educational transition to the next level and they are asked to face it as adults, together with their parents, in order to have better professional opportunities related to their education.

In various countries of the world, attending university, in an undergraduate study program, is not free, as it is in Greece, nor in a graduate program. Students are required, during their studies, to pay tuition fees to receive the required training from professors and to attend lectures, use university facilities and participate in examinations and other activities of their university. Of course, in order to attend a university, in addition to the direct costs related to tuition fees, there are also indirect costs related to living expenses in the city a student will decide to study, the purchase of textbooks, stationery, and equipment required for education, transportation, and other personal expenses. Because often the total cost of studies for a student is quite large, many students, who do not have the funds to support it, resort to borrowing from banks, with so-called student loans.

A student loan is a type of loan designed to help students pay for higher education and related costs. It differs from other types of loans in that the interest rate can be significantly lower and the repayment schedule can be postponed, while the student is still at university and studying, as he does not yet have an income. Mainly in the Anglo-Saxon countries, such as the UK, USA, Canada, and Australia, as well as the Netherlands and Sweden, it is observed that they are the ones where students borrow the most and take out such loans to finance their studies, with the first two winning the race. The fact that young people start their lives with a lot of debt after completing their studies has worried the governments of several countries. In the US, this is a burning issue with the average student loan debt per student hovering around $35,000. However, in England this debt is double, making it even more difficult and ranking it at the top worldwide, while the Netherlands, Canada, Australia, and Sweden have about half.

Student loan forgiveness

Recently, the government in the US, to deal with the intensive debt of young people in the country, decided to give away some of these loans and forgive part of the debt of several students who took out student loans, to help them. Public opinion has been divided by this judgment, which has been interpreted differently and has both fans and opponents. Therefore, we need to analyze student loans from a financial perspective, what loan forgiveness and debt relief mean, and look in detail at whom this decision affects. In the USA, it was decided to grant student debt forgiveness to new student borrowers up to $10,000 - $20,000 under conditions, as long as they meet the income criteria and earn less than $125,000 or $250,000 if married, annually. This move intends to help low-paid young people and improve their creditworthiness.

Debt cutting can be decided upon and carried out in a number of ways. One of them is from the creditors themselves, that is, from the bank that issued the loan or some other entity as a borrower. In this case, the lender negotiates with the borrower to cancel the rest of the debts, by presenting a lump sum payment. Not infrequently borrowers went to banks with bags full of cash and tried to negotiate the cancellation of the remaining debts by exchanging the cash in the bag, which was of course half of the outstanding balance of the debt! Other times the bank reduces some of the outstanding debt or settles the remaining payments to improve its repayment. Of course, all these choices are always made in the interest of the bank, which benefits either with extra interest or with massive liquidity in the case of one-off repayments; otherwise, there is no incentive for it to make such a transaction. Banks are also businesses and try to make a profit.

The other most common way is by a government with some law. This form of loan haircut can take many forms. It could be some government program where citizens participate based on social and income criteria and go to the bank to reduce part of their debt, but the government will pay it back through the program, along with interest. It may be a decision that obliges the banks to cut their debt, providing them in return in various forms such as exemption from taxation of future profits (deferred taxation) or government grants. Of course, it can also be something more drastic and strict, where with a decision the government forces banks and other lenders to cut the debts of citizens (or a specific group of citizens), without any compensation but with a penalty of non-compliance. This would be considered a major intervention in the market and the freedom of trading and would raise huge questions for many other products and businesses, scaring away investors. That is why, in the case of the USA, the fact that only those who have borrowed from the state, from student loan programs of the US Department of Education, are eligible to participate in the program. Thus, those students who have taken out loans with private banks will not be able to cut their debt, as the government chooses not to intervene in private matters.

Loan issuers and features of student loans

First, we should see who are the creditors of these loans to whom the students must repay the loans and what are their characteristics. In the US, 93% of student loans have been issued by the Ministry of Education and are backed by the government with guarantees, while the remaining 7% are by private banks and lenders. So, it seems clear that the US Department of Education is acting as a lender to the students to whom it gives loans to study and cover their tuition. In the other countries with heavy student loans, mentioned above, the state plays a dominant role, as the sole issuer of such loans. Thus, essentially the state is the entity that most students owe money, acting as an informal bank by offering funding programs-products.

The fact that the Ministry of Education grants loans to students to help them cover their expenses and study does not mean that it does so for free, without any benefit. As Milton Friedman once said, “there's no such thing as a free lunch”! These loans carry interest, just like any other loan, and students are normally charged interest. Since this is a financial service and the entire nation's tax revenue is being used to support a certain segment of the population, everyone should gain from it, not just the borrowers. So, practically with these student loans, it is as if the citizens of the country are lending money to some other citizens of the country. In the US, interest rates range from 4% to 7% for government loans and from 3% to 13% per year for private lenders. In the UK, borrowing is even more expensive with student loan interest rates ranging from 4.5 – 12%, recently capped due to inflation at an upper limit of up to 6.3%. It becomes clear that borrowing for studies, like any other borrowing, involves costs and in addition to the capital that a student borrows at the beginning of his studies, he will also have to pay the interest that has been calculated on it. Interest is charged as compensation to those who lent their money and deferred the consumption and the benefit of those funds for the future. Those who received the money today all together to use it are asked to pay this cost.

Loan calculation and payment schedule

Student loans are usually ten-year fixed-rate terms. Of course, there are also loans with different repayment periods or variable interest rates, or hybrid terms, but most student loans are issued with fixed interest rates. One of the most common ways loan installments are calculated is the fixed monthly or annual repayment method, or fixed amortization with equal repayments, as we finance geeks like to call it. This means that the borrower will collect the amount of the loan he applied for today to use and repay it together with the interest in equal fixed payments. Each monthly or annual installment consists of two things, principal repayment and interest. Principal repayment represents the amount that reduces and repays the principal that the student originally borrowed and must pay back. The interest refers to the profit of the borrower, depending on the agreed interest rate, and is calculated on the outstanding remaining principal each period.

To better understand it, I present you an example of this year's student, who wanted to study and was enrolled this year in a US university, in which he has to pay tuition fees for a three-year undergraduate program amounting to $30,000, paid in 6 equal installments (so each semester he will give his college about $5,000). However, the total costs of the studies will probably be twice as much, if we include living expenses and other indirect costs. So, he decides to borrow $50,000 from the US Department of Health with an annual interest rate of 6% and the repayment frequency will be annual, that is, he will pay a fixed installment every year. The loan repayment method is detailed below.

As shown in detail in the above table the student will pay a fixed installment of $6,793 for each year, with the first installment at the end of this year 2022. The interest is calculated on the outstanding amount of each period applying the 6% interest rate. Since in the early years the outstanding amount is larger, the percentage of the installment that goes to paying interest is larger, which then decreases over the years and more of the money goes to repaying the principal that the student borrowed. Finally, after 10 years when that student pays off the $50,000 in debt he borrowed today, he will have paid an additional $17,934 in interest, as the cost of borrowing. The total money he will have given the lender, whether borrowed from the State or a private body, will be $67,934.

Of course, this scenario is not that realistic, as for the next years that the student will study, he will not have any income to be able to repay his first installments, which means that he would either need help from his parents or would ask for a grace period. The second is the more common scenario with most loans allowing students to take out the loan money today to cover their expenses and begin repaying the loan when they finish their studies and find a job. So, for some years they don't pay anything to the bank and along the way, they start paying the installments when they find a job and have an income. However, during those years when the student does not pay anything, the principal is compounded as normal, and the interest is calculated and capitalized, increasing the amount owed by the borrower after the grace period.

Continuing the above example above, suppose our student is given a 4-year grace period, of which 3 years are spent in his academic program and 1 year is spent looking for a job that will provide him with enough income to cover the annual installments. The repayment schedule in this instance will be as follows.

As you can see, things are changing noticeably. Initially, we see that the installments will start to be paid in 2026, due to the four-year grace period. However, due to the capitalization of the interest, the amount owed at the start of repayment is greater than before and, by extension, the amount of the installments. The student will eventually be asked to pay 85,765 of which 63,124 is the principal and the remaining 35,765 the interest. A significantly increased amount compared to before where he will return 67,934 while now 85,765, 17,831 more! This is the cost of the extra option provided by the bank to the student with the grace period! It would help if, during the grace period, our student would pay at least the interest so that they don't have time to capitalize and increase the remaining repayment amount due, but as we said, the student for the first 4 years will have no income!

And all this if the 10 years of repayment are added to the grace period. In the event that the grace period is included in the decade, then within 6 years, the student should be able to pay off all of his debt, which would rapidly increase his annual installment, however, it would slightly limit the interest and the total debt. The situation would be as shown in the table below.

Of course, in such a situation, the installment seems large enough to be able to be satisfied and the student should find a really good high-paying job to be able to pay at the end of each year $12,837 as a loan installment.

In case many of you are wondering if he could choose a monthly payment plan to pay smaller installments but every month, keeping up with his monthly income and not once a year altogether, I will point out that this will increase the interest quite a bit! The higher the frequency of repayment and compounding of an amount in one period, the higher the interest, and you are required to pay even more in interest. In banking, any facility has a cost! The best thing you can do in a loan agreement to win is to pay off your debt as early as possible so that the interest is not capitalized.

Debt Relief – Loan Forgiveness

The US government, to help low-income earners with debt, will grant debt forgiveness of $10,000 to $20,000 on either new loans or the unpaid balance of older loans. To make it easier to understand if we assume that the student in our example received $10,000 in relief the three situations before and after debt relief is set up as follows.

Of course, the relief also occurs in older loans and is applied to the remaining amount balance for repayment. In this case, the debtor's remaining principal will be reduced by one point and his installments will be adjusted. In this way, their payments will be facilitated and the amount of interest will also be reduced, as the principal balance on which the interest is calculated is reduced. A similar example of a student who had previously borrowed $10,000 on the same terms goes like this:

Who is affected by this program?

As this loan forgiveness is an economic policy and an economy involves many stakeholders, this decision affects many either positively or negatively. Let's analyze how everyone is affected individually to finally see if this policy helps and adds value.

BORROWERS

Borrowers are the main beneficiaries of this policy. Suddenly they see their debt reduced by $10,000 – $20,000 and by extension, the interest calculated each year on the remaining principal owed. Especially those who had taken out high-interest loans are starting to smile more! At the same time, participants in this program will see their installments adjusted downwards leaving more disposable income to consume or invest as they wish. Of course, there is a catch hidden here. The fact that they have more disposable income will increase their annual taxation, as the taxable income will now be greater than before since they will not have as many expenses in loan installments. Therefore, in the end, the benefit for the borrowers is marginal and would probably be characterized as neutral. The only positive thing for them is that they will not pay as much in interest and they will improve their creditworthiness.

BUSINESSES

Generally, businesses in the economy are not directly affected by this policy. Perhaps businesses could be positively affected, due to the higher disposable income consumers would have, but it is not certain that it will be enough since the tax liability of consumers will increase. The minimum consumption will not be enough to affect the profitability of the companies and improve their stock prices. On the other hand, they may see their new employees calm down psychologically after such a relief, improving their productivity. Freelancers or new entrepreneurs starting a small business will improve their credit rating and may be able to obtain better financing. Thus, we could say that businesses will benefit marginally and indirectly.

BANKS

Banks also remain neutral as they do not benefit, as student loan debt relief only applies to loans that have been granted by the government. Those borrowers who have taken loans to study directly from private banks will not be helped at all, because as we said above such a write-off would be considered a major interference in the banking industry, affecting the efficiency and profitability of the bank. Of course, this move creates concerns in banking circles, as there is always a possibility that in the future there will be a similar program that includes private banks because moves have begun to be made in the student loan problem, worrying bank shareholders and investors, about loss capital and diminishing returns. A possible program, that would also include private banks that hold student loans (which are a small minority), would affect the banks' profitability and pass that loss on to future new customer loans, making borrowing costs a bit more expensive due to higher interest rates that they would charge to offset the losses for their shareholders and to protect their stock price on the stock market, which would already have fallen.

GOVERNMENT – MINISTRY

The Ministry of Education, which is the issuer of these loans, will be the only doubly loser. On the one hand, all this debt cancellation cost will be incurred for the forgiveness of part of the outstanding capital of 10,000 – 20,000 $ and on the other hand, it will reduce in this way the interest-bearing obligations of the borrowers, reducing the revenue and profits for the state from this loan agreement. In general, lenders do not prefer payments all at once because this reduces their interest income, since the interest, as we said, is calculated each period on the remaining outstanding capital, which the longer it remains unpaid the higher the interest will be, which is also the basic income of lenders. Of course, the state is not worried about the latter because this relief will create more disposable taxable income, increasing the tax liability of the borrowers. Thus, instead of more interest, they will pay more taxes to the state. In addition, given that the state is the largest issuer of these loans, we are no longer talking about debt relief but a transfer of debt from one account to another, from borrowers to the general population, burdening even those who have not received the corresponding borrowing. The funding of the above relief program will be financed by US cash reserves and possibly by issuing new debt through bonds. This will increase the national debt and reduce available cash, which could be used for other policies and infrastructure, thus creating a huge opportunity cost.

OTHER CITIZENS

The rest of the citizens who have not taken out such loans either, because they did not want to or because they never had to, are the ones who, as taxpayers, will indirectly shoulder the debt of others. They are setting a dangerous precedent here, as someone who sacrificed choosing better universities to study in order to be debt free, is being called to pay the debt of someone who enjoyed this improved and more expensive service, by raising debt, which is suddenly partially forgiven! This creates a moral hazard of ex-post inefficient use of funds. Debt relief does not encourage serious protective, conservative borrowing choices, but instead rewards careless and irresponsible behavior. No student loan borrower can claim that they did not know the outcome as they signed the terms of the loan, nor that the interest rates were unfavorable as they are at the market average and agreed on them. A borrower should be able to pay what he owes and has promised to pay on his own, otherwise, debt relief is a mismanagement of public money. Furthermore, such situations will create the problem of adverse selection in the future, i.e. the pre-attraction of insolvent borrowers, who are bad customers with low credit scores who actively seek loans by accepting various terms, knowing that they may be helped or required by some new program to be helped, as previous student borrowers were helped. Moral hazard and adverse selection are two basic categories of problems that in banking are included in the general term of information asymmetry, a situation that arises when insufficient knowledge of one party about the other party involved in a transaction makes it impossible to obtain rational decisions when conducting the transaction.

Wrong timing for the economy

The timing of this policy in the fall of 2022 is economically wrong. The world economies are faced with the serious issue of rising inflation in 2022, which had not been an issue in Western economies for many years. This problem is primarily caused by an imbalance in the supply of goods as a result of the coronavirus's reduced production in previous years, and it is secondary to the high circulation of money as a result of the aid packages provided by governments to their citizens during lockdowns. Central banks and governments are two organizations that can offer remedies with particular tools to address this economic problem. Central banks worldwide, one after the other, are reducing their expansionary policy and starting to implement restrictive monetary policy, using the tool of lowering interbank market rates, in order to limit the circulation of money and tame inflation. This rise in interest rates will make money more expensive for banks, who will lend it at a higher rate to cover the increased cost of borrowing, and by extension, this higher cost of borrowing will discourage many new loans to be issued, consequently reducing the money supply. Of course, the effects of this monetary policy, with the reduction of interest rates, take time to complete this cycle of chain reactions and reach the real economy, restraining the continuous rise in prices and mainly affecting a part of society, through lending activity. At the same time, governments should participate in accelerating the resolution of this problem with corresponding measures of conservative fiscal policy that limit the circulation of money, but also with targeted aid that focuses on facilitating the treatment of the problem of reduced supply on which inflation is based. However, instead, we see in the US, through student loan forgiveness, an expansionary fiscal policy is being implemented, increasing the disposable income for consumption of a portion of the population and intensifying the problem of inflation. This policy increases the circulation of money, along with others like it, delaying the resolution of the problem. Unfortunately, we have only one party, the central banks, fighting to solve inflation, but they only have one tool to deal with it and that is interest rates. Constantly, both the Fed and others are making successive interest rate increases to limit the money supply and hold down the prices of consumer goods and services, which is their primary role.

The macroeconomic problem of creating debt for studies

For America, the issue of student loans and the significant debts that young people must deal with when they enter the workforce after completing their studies is quite serious. In addition to the psychological effects on a young person's life, starting off in debt restricts their income for consumption, lowers their creditworthiness for other loans like business or housing loans, and decreases tax revenue for the government. In addition to being unfair because it does not apply to the entire population, partial student loan forgiveness is also economically inefficient because it increases US debt, which could make future financial projections difficult for the country. However, this is not solving the problem, just moving the problem into the future, as young people will continue to take out student loans to cover the rising cost of education.

The main problem with student loans and debt is twofold. On the one hand, the question must be answered as to why the cost of higher education is so high and continues to rise. On the other hand, the question of why student loans are granted so easily must also be answered. A number of business people have occasionally asked the public, "How is it that someone can get a student loan just by showing their registration, which can be to a student with questionable credit and it's really hard for a new entrepreneur to get a loan to buy business equipment, who has a better chance of generating positive cash flow from the products he will produce and sell, as well as collateral for the loan?" Are the two problems connected? Are tuition fees rising as institutions know that students can easily raise loan finance? Are loans made easy as they are backed by the government in case of default, which can easily raise funds either from taxation or from issuing bonds, creating additional debt in the country?

Other countries

Great Britain has an even more severe problem with student loans and debt among young people after university. There the per capita debt is twice that of the USA and the discussion about its gradual treatment has not yet started. In contrast, countries such as Sweden, the Netherlands, and Canada are faring much better with lower debt per capita for young people after graduation and student loans with low servicing costs, with loan interest rates below 1%. With these interest rates, it makes sense to take out a loan as a student, even if you don't need it, to invest the money and repay the loan from the income you will get! And when the repayment is over you will have something tangible left for you. You can buy an income-producing asset, such as some high-dividend-yielding stocks or ETFs, or some corporate or government bonds that pay good coupons. Of course, you wouldn't be able to buy a property to rent it out and have income, since the student loan funds raised wouldn't be that much, but you could very well buy shares of some REITs, which are real estate investment companies and work exactly like a property that you would buy to rent out and collect the rents, without the hassle of management! Fortunately, in Greece, there is no such problem, where the cost of higher education remains quite low, with undergraduate programs being free while the average cost for a master's degree is around €4,000. In addition, there is the possibility of providing free textbooks for all courses of study and other student grants and discounts, further reducing the cost of study, which is not the case in other countries, setting a global positive precedent and providing a competitive advantage to graduates with improved credit.

Conclusions

Looking at what I've written above before I hit the publish button to share with you, I'm not sure how much these debt relief measures ultimately help young people while they certainly surprised and upset quite a few others, without strong economic benefits and substantial improvement. They are certainly a fire-fighting solution to a larger problem that the US needs to study in order to improve the economic situation of its youth. Of course, it is not the only country that has to do it, as in England the problem is bigger and multidimensional, which is still left out of discussions. Banking and lending are complex mechanisms where you cannot change one variable without affecting another, so they require complex, holistic, and imperative solutions with strategic planning at multiple levels.