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A vision for reforming student loans

This month, high school seniors across the country are receiving acceptance notices from colleges and universities. They will now confront the challenges of financing their higher education plans, and the decisions they make today will determine what kind of personal debt burdens they will have in their twenties and beyond.

Student debt has become a significant barrier to achieving the American dream. With outstanding debt topping one trillion dollars and the default rate on federal loans approaching 15 percent, many borrowers are finding themselves in a spiral of debt and financial ruin. This week, the Federal Reserve announced that American consumer debt is higher than it's ever been, with student loans leading this surge. This has serious long-term implications for our economy and a whole generation of young Americans.

From left: Marco Rubio and Tom Petri
Source: Wikipedia
From left: Marco Rubio and Tom Petri

How should we approach a solution? It's helpful to break the discussion into two parts: First, our repayment system for federal loans is broken, causing untold numbers of defaults. Second, we must implement reforms to lower college costs while improving quality.

It's important to note that a significant number of borrowers default on small debt levels. In fact, the average amount of a defaulted federal loan is roughly $14,000. Many of these defaults occur because our system focuses the burden of repayment on a borrower's initial years out of school when he or she is least equipped to bear it. As a result, temporary struggles to find a job right out of college or low initial earnings turn into needless defaults. And while other options exist, the system's bewildering complexity prevents many students from taking advantage of them.

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Far better would be to have each borrower's payments set automatically as an affordable percentage of income. For most, this would mean paying less early in their careers and more as their income grows over time. Additionally, borrowers would be protected from income shocks such as unemployment, something many recent graduates have struggled with during the economic downturn. It's a small fix that would make a big difference.

President Obama has talked about similar ideas through his "Pay As You Earn" plan. However, his focus has been to expand loan forgiveness while doing little to address the confusing bureaucracy that causes so many borrowers to fall through the cracks.

This approach is fundamentally wrong and will only reward over-borrowing while leaving taxpayers holding the bag. Instead, young workers need a streamlined and dynamic repayment system that automatically adjusts to their ability to pay over time. This would protect them from the financial ruin of default but in a way that is fiscally sustainable, fair and that encourages prudent borrowing.

Second, in addition to reforming our repayment system, we must attack the burden of debt directly by improving the quality of higher education while lowering its cost.

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To do this, we should embrace innovative financing tools that would better serve students and bring market forces to bear on the higher education system. One promising idea, originally proposed by Milton Friedman and discussed in a recent report published by the American Enterprise Institute, would have investors provide students with money for school in exchange for a percentage of their income for a set period of time after graduation.

These income-share agreements would have no principal balance to repay, so a graduate whose educational investment does not pan out or who ends up in a less lucrative field than anticipated could end up paying less than the original amount provided. Also, because graduates are simply paying an affordable percentage of their income over the specified time period, they are protected during periods of low income. Investors would also have strong incentives to provide students with support and mentorship during and after their studies, something particularly beneficial to low-income students who often struggle to navigate the higher education process.

Additionally, investors would likely vary the percentage of income they are asking for depending on a program's track record. This would give clear signals to students about what programs are likely to be most helpful to them when they enter the workforce. It would also help connect students with fields that are in demand and would put pressure on institutions to increase quality and lower costs.

While there are a few small companies experimenting with this idea, the lack of an established legal framework regarding consumer disclosures, tax treatment, and other important aspects of these plans has prevented the growth of this market. Therefore, we will soon be introducing legislation to provide this needed clarity so that a broad array of students can have access to this innovative financing option.

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Lastly, Congress should pass legislation giving students and parents more information about the performance of graduates from different institutions and programs, empowering students to choose a program that will set them up for success. At the same time, we should look for ways to eliminate barriers that block new and innovative entrants that could shake up the system with new models designed for a 21st century student body and workforce.

There is no silver bullet for student-loan reform. However, by putting in place a streamlined and dynamic repayment system for federal loans, we can protect students and taxpayers from the disastrous financial consequences of default. And by pursuing other reforms that bring market forces and transparency to our higher education system, we can empower students and parents while helping to foster an education system that is more competitive, dynamic, and responsive to student needs.

With Congress set to consider reforms to our nation's higher education laws as early as this year, these ideas would be a good place to start fixing the way our people acquire the knowledge and skills to achieve their dreams in the 21st century.

Sen. Marco Rubio (R-Fla.) was elected to the U.S. Senate in 2010; his committee assignments currently include commerce, science and transportation; foreign relations; intelligence; and small business and entrepreneurship. Follow him on Twitter @marcorubio.

Rep. Tom Petri (R-Wis.) was elected to the U.S. House of Representatives in 1979; his current committee assignments include transportation and infrastructure and education and workforce.