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This is how you take the confusion out of repaying student loans

February 11, 2015, 4:30 PM UTC

Over seven million people are in default on more than $100 billion in federal student loans, up by half a million people from only a year ago. To solve this crisis, members of Congress like U.S. Sen. Elizabeth Warren have proposed cutting interest rates and paying for it with a tax increase, but there’s a better way. The government can eliminate interest rates on federal student loans altogether — without asking taxpayers to foot the bill.

The idea is to price the extra costs of a loan that are typically covered by interest into a one-time origination fee. This would make repaying feel more transparent and less frustrating, since the balances on these loans would fall faster and never go up. Additionally, under the right circumstances, this plan would be extremely beneficial to low-income borrowers.

Here’s how it could work: Say a student borrows $10,000 at an interest rate of 5% over four years. Assuming she makes on-time monthly payments for 10 years after graduating, she will have paid about $14,000 in total. So why not just make her loan balance $14,000 from the start, which would include a $4,000 origination fee that she can also borrow to cover the cost of the fee?

Of course, the costs to service the loan and compensate for the risk associated with it are still being borne by the borrower — the idea is not to massively increase the generosity of the loan program. So while borrowers still pay what they would under the current system, their balance never goes up — interest never accrues.

That’s a big deal for two reasons.

First, one of the big issues I hear from student borrowers is that they’re surprised by how big their loan balances are when they leave school. This isn’t from negligence. Student loans are different from other types of loans because they typically accrue interest while a borrower is enrolled in school, but the borrower is not required, and is typically unable, to repay the loan during that time. As a result, borrowers’ loan balances upon leaving school are far higher than the paperwork they signed would suggest.

Second, this idea could actually be a boon to low-income borrowers, so long as those borrowers take advantage of the government’s income-based repayment plan, which bases borrowers’ payments off of their income. That’s because, in a world of no interest accrual, the longer a student takes to repay her loan, the cheaper the loan becomes, and in a system in which payments are based on income, the people who would take the longest to repay are the ones making the least money. In this case, time really is money.

Going back to the earlier scenario, where someone paying for 10 years with that $4,000 origination fee pays the same amount as someone who had a loan with an interest rate of 5%. If the student makes a really high income right out of school and pays off the entire loan during the first year, the loan, in retrospect, would look similar to a loan with a 9% interest rate. If she took 20 years to pay it off, it would look closer to 2%. To be sure, the math is imperfect, and it would depend how the government prices the origination fee. The general idea, however, is that charging a one-time fee upfront, rather than interest that grows daily, would allow borrowers to know exactly how much they will owe at the time of signing for the loan.

This might seem like a radical idea, but it has the potential to make the student loan process far more transparent, progressive, and palatable for millions of borrowers in repayment. The answer to the problems around student loan interest isn’t to slightly lower the rates, but instead to rethink how a loan ought to work altogether.

Alexander Holt is a policy analyst with the education policy program at New America, where he focuses on the economics of higher education.