Now that we’ve decided on a loan system, we have to start thinking about how we are going to recover any money that we lend. 

For decades, student loans only worked one way: on a regular amortization basis.  If you borrow, you repay on a regular monthly basis after graduation, just like one pays a regular amount each month on a mortgage.  Even within this framework, there are a lot of policy elements one can adjust.  The length of the repayment period can be fiddled with: in Asia, they prefer short periods like four years for loan repayment, we prefer longer periods like ten or fifteen or even longer in the United States.  Basically, the only thing going on here is a trade-off between individual monthly payments and higher total interest payments.  There is also the question of a grace-period and how long it takes for repayment to actually start.  In most countries the period is somewhere between six and twelve months; in its re-election platform the Liberal government suggested two years, and in Germany it is five.  Assuming the government is paying for interest during the grace period (not always the case), this is simply a matter of generosity on the part of government.  However, assuming funds are limited, government “generosity” in one area may mean fewer loans overall.

Another big question is the nature of interest rates on loans. Do you charge them?  If you charge them, at what point do they start accumulating?  In most countries where interest accumulates, it does so from the moment the loan is taken out; in North America, interest is zero (i.e. negative real interest) while the student is in school.  At what rate do you charge them?  Equal to inflation like in Australia?  Equal to the government cost of borrowing as in the Netherlands?  Some higher level which is lower than market rates, but which still produces enough surplus to offset loan losses, as in Canada?  These are all important decisions that need to be taken.  Again, generally speaking, the more “generous” the government happens to be in any one area, the less able it is to be generous in others.  It is, as always, about balance.

The other alterative is to do something called “income-contingent loans”.  The exact definition of this is vague, but usually these are loans collected through the tax system, calculated as a percentage of total income (or marginal income above a given threshold), as in the UK, Australia and New Zealand.  This is not the only way to run income-contingent systems; in fact, most systems have some kind of income threshold below which repayment is suspended.  Some – like Canada and the US – have “income-sensitive” systems where low-to-middle-income borrowers are relieved from paying the full amount of what is owed.   These programs tend not to use the tax system for collection.

(Basically: income-contingent loans don’t need to be collected by the tax system, and you can use the tax system to collect loans that aren’t income contingent.  But people confuse the two issues all the time).

The “full” income-contingent system is sometimes seen as the most generous and flexible system and holding the level of student debt constant that’s probably true.  Where income-contingent debt gets weird is in the way it effectively abolishes the possibility of loan default.  On the one hand, this is good for students; on the other, it means government has a hard time getting a signal about how well repayment is going.  This is a problem particularly if you have high debt levels and a generous forgiveness clause, like the UK does: this results in a system where something like half of all debt will never be repaid and something like 70% of all borrowers will receive some forgiveness.  This is either a feature or a bug, depending on your point of view.

Whether you have an income-contingent or a mortgage-style loan, you have to make some decisions about collections.  In the few countries with simple, effective tax systems where the unit of taxation is the individual (as opposed to the family, as it is in the US and France, for example), it makes a certain amount of administrative sense to use the tax system to recover loans, and the use of the tax system certainly makes repayment based on income easier.  But it is not fool-proof, because not everyone pays taxes, some people leave the country, etc.  In the UK, Australia and New Zealand, there are still 10-25% of borrowers who are outside the payment system; in income-continent countries with laxer tax systems (Ethiopia, say), it is 50% or higher. 

But say the tax system isn’t an option – what then?  Well, in many countries this question tilts the playing field towards having the banks do it because they are already expert in recovery – and this in turn tends to lead to a decision to bring the banks in at the front end as well through a loan guarantee (see yesterday’s blog).  But while that might work in places like, say, Malaysia, in countries with no national ID systems, or phone directories, or fully-functioning social security or even cadastral systems – most of Africa and developing Asia, in other words – the banks don’t necessarily have an advantage because under normal conditions they restrict their lending to a more stable clientele.  In theory, you could hire debt collectors, but they are working under the same restrictions.

What many governments now do – especially in Africa where mobile money and online payment though platforms like M-PESA has become a dominant means of money transfer – is just create their own repayment agencies outside the regular tax system.  And they are pretty good at it: loan repayment in some African countries is now over 50% or so, which may not sound like much but is a massive improvement over the norm a decade ago. This is allowing a lot of new borrowing to occur.

So, to sum up:

• Income-contingent vs mortgage-style repayment is only one of many decisions to make in terms of loan repayment design.
•  Having the administrative capacity to track students and secure repayment is maybe more important, since loan recovery rates condition the availability of future loans – whether that capacity comes through the tax system or somewhere else is secondary.
•  Decisions on repayment subsidies (especially interest subsidies) can have significant financial implications.

To this point, we’ve looked at debt recovery in the absence of any discussion about the absolute level of debt itself.  To do that properly, we need to start looking at the question of loans vs. grants, which is our subject for tomorrow.