Federal Student Loan Defaults: What Happens After Borrowers Default and Why
American Enterprise Institute
August 13, 2018
Key Points
- Observers often think of student loan default as a terminal status. But 70 percent of borrowers bring their federal loans back into good standing within five years after default.
- Five years after defaulting, 30 percent of borrowers fully pay off their loans. Others bring their loans into good standing through resolution processes, but typically do not make progress paying down their loans even several years later.
- Within five years after exiting default, 30 percent of borrowers take out more student loans, and another 25 percent default again on new or existing loans
- Defaulters who pay down their loans can incur large fees, but fees are largely waived for those who complete resolution processes even if they do not pay down their balances afterward.
- The default resolution policies are complicated and counterintuitive, and they can treat similar borrowers differently for arbitrary reasons. We recommend a simpler and fairer system that levies a consistent fee, protects taxpayers, and allows for faster resolution after the first default.
Introduction
While student loan default is a topic well covered by academic literature and the media, most of that analysis has focused on what predicts default with an eye toward preventing it. However, very little research looks at what happens to student borrowers after they default on federal student loans. Federal loans make up some 90 percent of student debt. Often, default is portrayed as a terminal status that is financially catastrophic for borrowers and entails large losses for taxpayers.1
A lack of borrower-level data on loan performance has made it difficult to test whether this characterization is accurate—or to understand even basic facts about what happens to loans after default. Publicly available data related to loan defaults are limited to aggregate statistics computed by the Department of Education (ED) and the New York Federal Reserve, as well as three-year cohort default rates at the college and university level. Such data are useful to assess rates of default and the characteristics of borrowers who default, such as school type and loan balance.
But the available data do not provide a picture of how a borrower’s default status evolves over time. For example, there is little concrete information on how long loans stay in default, how outstanding balances change during and after default, and how federal policies to collect or cure defaulted loans affect borrowers’ debts. Without this information, it is difficult to determine whether current policies surrounding default are fulfilling their intended purposes and where there is still room for improvement.
This report aims to expand the window into federal student loan defaults beyond the event of default itself. It attempts to provide the most robust look to date of what happens to student loans after a borrower defaults and why. Ultimately, this information should help policymakers evaluate the current set of policies related to default collections as well as pose new questions for researchers to explore.
Note that this analysis focuses on government policies, such as exit pathways, fees, and interest related to default, as well as borrower repayment behavior. It does not examine other consequences borrowers experience due to default.
The report is divided into two sections. The first section analyzes a new data set from the National Center for Education Statistics (NCES) that tracks how the federal student loans of students who began college during the 2003–04 academic year perform over the following 13 years.2 We answer questions such as how long borrowers stay in default, what paths borrowers use to exit default, and how balances on defaulted loans change over time. The second section uses hypothetical borrower-level examples to simulate the effects of default—such as interest, fees, and penalties—that accrue on the loans. These examples are informed by the preceding data analysis and are based on extensive research into government policies for collecting defaulted loans and helping borrowers exit default.
Overall, our findings suggest that the popular impressions of borrower outcomes after default, even among policymakers and researchers, are overly simplistic. There is no one typical path borrowers follow after defaulting on a federal student loan. While some borrowers stay in default for years, others leave default quickly. Some borrowers see their balances rise throughout their time in default, while others pay down their loans in full. These outcomes do not always correlate the way one might expect: A borrower who has exited default often has not repaid his loan (although he may eventually), and a borrower still in default is often making rapid progress toward fully repaying his debts.
Collection costs that borrowers pay in default can be large, just as the popular narrative says, or they can be minimal to nonexistent.3 That is because the federal government has erected a complicated set of options and policies for borrowers in default. These policies are often counterintuitive and include perverse incentives for borrowers in how they resolve their defaults. Harsher penalties are imposed on borrowers who quickly repay their loans in full after defaulting than on those who engage in a lengthy, bureaucratic “rehabilitation” process but make no progress in paying down their debts. These findings suggest there is plenty of room for lawmakers to change policies governing default in order to make the process of exiting default simpler and more rational.
Notes
- Robert Gebeloff, “Projections for Student Loan Defaults Are Terrifying. It’s Time to Act.,” Washington Post, January 22, 2019, https://www.washingtonpost.com/blogs/post-partisan/wp/2018/01/22/projections-for-student-loan-defaults-are-terrifying-its-time-to-act/.
- Other researchers have conducted analyses on this dataset, although they mostly did not focus on post-default outcomes. See Ben Miller, “Who Are Student Loan Defaulters?,” Center for American Progress, December 14, 2017, https://www.americanprogress.org/issues/education-postsecondary/reports/2017/12/14/444011/student-loan-defaulters/; and Judy Scott-Clayton, “What Accounts for Gaps in Student Loan Default, and What Happens After,” Brookings Institute, June 21, 2018, https://www.brookings.edu/research/what-accounts-for-gaps-in-student-loan-default-and-what-happens-after/.
- Robert Hiltonsmith, “Small Loans, Big Risks: Major Consequences for Student Debtors,” Demos, 2017, http://www.demos.org/sites/default/files/publications/Small%20Loans%20Big%20Risk%20.pdf.