Consolidation of Student Loan Repayments and Default Incentives

Abstract

I study repayment behavior for college graduates who borrow under the U.S. Federal Student Loan Program to finance higher education. I develop a dynamic model with uninsurable shocks to earnings and student loan rates that explains the repayment pattern in U.S. data: college graduates with lower debt will lock-in interest rates, while those with higher debt will switch to an income-contingent plan. Default does not occur among the most financially constrained group of college graduates. I use the model to quantify the effects of a reform introduced in 2006 that eliminates the possibility to lock-in interest rates for student loans. The reform induces a significant increase in default rates, which is largely accounted for by low-income borrowers.