In the intensifying debate over student debt forgiveness, we have noticed some confusion about how cancellation would affect the federal budget. Understanding how the government treats loans in its budget is helpful for understanding potential trade-offs between student loan cancellation and other policies to support the struggling economy, increase economic opportunity, and promote racial equity. Here we answer some basic questions about how student loans affect the federal debt and deficit.
From a budget perspective, what happens when the federal government makes student loans?
The federal debt increases when the federal government makes student loans. The federal deficit, however, typically ount. This can be confusing because the debt and deficit usually move together. If the government spends an extra $100, for example, the debt and the deficit both increase by $100.
Student lending works differently because student loans are valuable financial assets. The government borrows money to make the loans. It expects interest and principal payments in return. To calculate the deficit effect in the year the loans are made, the government compares the amount of the loan to an estimate of the present value of those future loan payments. Even though these estimates reflect payments well into the future, their value is accounted for in the budget deficit the year the loans are made.
As of March (PDF), these estimates showed student lending would, on average, modestly reduce the deficit. A $100 loan, for example, might generate a $3 surplus. Some loans would do better and others worse, but on average, the government expected returns on the loans that are repaid to be slightly higher than the losses on loans that are forgiven or defaulted.
What happens when borrowers make loan payments?
The federal debt decreases when borrowers make loan payments. The government receives the money and thus, can borrow less than it otherwise would.
The effect on the deficit depends on how loan payments compare with what the government predicted. If payments exactly match expectations, there is no deficit effect. If borrowers, on average, pay less than the government expected, the deficit increases. That might happen because of unexpected defaults or because borrowers prepay loans the government expected to generate future surpluses. If the reverse happens, the deficit decreases.
What happens if the government cancels the debts?
Suppose the government made a $100 student loan in January and estimated it would bring in a net surplus of $3 over its life. If nothing had changed since January, cancelling that debt would increase the deficit by $103. https://badcreditloanshelp.net/payday-loans-mo/ The government would lose the $100 face value of the loan plus the $3 surplus it expected. (There may also be an effect on tax revenues. That depends on whether the government treats loan forgiveness as taxable income.)
Many things have changed this year, however. The ongoing economic crisis increases the potential for defaults or loan forgiveness through existing income-based repayment programs-both of which lower the value of existing student loans. Plummeting interest rates, on the other hand, have increased the value of existing loans because their interest rates are fixed, and the interest rates at which the government borrows are not. The current value of the $100 loan might be more or less than $103, depending on how the government weighs those changes. Whatever it is, that new value would be recorded as the deficit increase from loan forgiveness.
Cancelling student debt has no immediate impact on the national debt. The money that funded the loans is already out the door. But the debt will eventually be higher because the debts don’t get paid back. That increase shows up over time when expected future loan payments do not get made.
Many borrowers default on their student loans. Because these loans wouldn’t be paid back anyway, doesn’t this diminish the net effect of debt cancellation?
Yes, potential defaults reduce the current value of outstanding loans. The same is true for income-based repayment programs that forgive some debt after 10, 20, or 25 years. On the other hand, student borrowers pay interest at a rate higher than the US Department of the Treasury’s borrowing rates. The government thus anticipates coming out ahead on loans that borrowers do repay.
Early this year, government agencies expected the interest gains on new loans to be bigger than expected defaults and scheduled forgiveness. But conditions have changed, and forgiveness would apply to loans made in the past. Ultimately, the deficit and debt effects of loan forgiveness depend on the value of the future payments we now expect, not just on the face value of the outstanding loan balances.
Many people support running deficits during weak economic periods. Wouldn’t the deficit increase from debt forgiveness help the economy recover?
The deficit increase from loan forgiveness would do relatively little to boost the economic recovery. Government spending increases and tax cuts can stimulate the economy by putting money in people’s pockets quickly. Forgiving student debt would eliminate monthly payments, but most benefits would come years in the future. Suspending current payments, as done in the CARES Act, would provide the same stimulus now, but at lower long-run cost to the government. Loan forgiveness could provide some stimulus because borrowers feel less financially constrained. But because the benefits would not be fully realized for many years, it would provide a much smaller boost to the economy than policies that get money to struggling people quickly, like expanded unemployment insurance.
Does it really matter if loan forgiveness increases the deficit next year or the debt in the future?
Political leaders, experts, and commentators differ greatly in their view about deficits and debt. Some believe they matter little with interest rates so low. Others worry deficits and debt can eventually weaken our economic capacity through inflation, reduced domestic investment, or increased reliance on foreign funding.
Cancelling student loans will increase the national debt gradually in the long-term and will increase the deficit in the year the loans are forgiven. Policymakers and advocates should worry about that increase to the same extent they worry about debt increases resulting from other policies.
A US flag flies above a building as students earning degrees from Pasadena City College participate in the graduation ceremony, on , in Pasadena, California. (Photo by Robyn Beck / AFP via Getty Images)