Obama's Proposed Student Loan Debt Remedy Carries a Hidden Trap

Students  listen to then national anthem prior to US President Barack Obama's  delivering of the commencement address on May 21, 2012 at Missouri Southern State University in Joplin, Missouri. AFP PHOTO/Mandel NGAN        (Photo credit should read MANDEL NGAN/AFP/GettyImages)
Mandel Ngan, AFP / Getty Images

America's student loan debt problem is nothing new: For years, the media has been offering up a flood of stories about people facing decades of debt repayment and crushing interest rates. But with tuitions still rising and employment options for college grads still stagnating, America's potential "student loan bubble" is making many experts increasingly jittery. President Obama's recent budget proposal includes a new plan to tackle the problem, but some critics worry that it could leave students in even worse shape.

Pay As You Earn, President Obama's first stab at the student loan issue, came late last year. The program caps student loan repayment levels at 10 percent of the borrower's discretionary income, effectively ensuring that recent graduates won't get stuck with brutal monthly payments. At the same time, the program also places an effective limit on the length of repayment: After a student has been paying off their debt for 20 years, the program will retire any debt that remains.

It's a great idea, and could go a long way toward ending the student loan debt carousel that so many workers are stuck on. Unfortunately, there are some rather severe caveats. To begin with, Pay As You Earn is only available to students who have taken out at least one student loan after fiscal year 2011. In other words, people who are already in repayment hell are stuck there.

Also, the program only applies to federally backed student loans, which means that many people struggling under the worst loan debt -- those who took out higher-interest private loans -- are ineligible.

What the President Proposes

Last week, President Obama debuted another balm to ease student-loan miseries, but the remedy is paired with another potentially devastating long-term consequence.

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Here's how it would work: Currently, Congress sets a cap on student loan interest rates, but Obama's proposal would peg student loan interest to the market. Under the proposed system, 10-year Treasury notes would be the benchmark for loan interest. The interest rate on subsidized Stafford loans would be the Treasury note rate, plus 0.93 percent; on unsubsidized Stafford loans, it would be Treasury rate plus 2.93 percent; and on loans to grad students and parents, it would be Treasury plus 3.93 percent.

Today, the Obama proposal would be a considerable benefit to students. It would lower the subsidized Stafford loan rate by 0.65 percent, the unsubsidized Stafford rate by 2.05 percent and the grad rate by 1.05 percent. The trouble is that the Treasury note interest rate is currently near historic lows and is almost certain to rise if the economic rally ever kicks into gear. As The Atlantic noted, there are times during the past few decades when -- under the proposed plan -- student loan interest rates would have jumped above 12 percent.

It's also worth noting that Obama's interest rate proposal doesn't do much to address a basic problem of student loan repayment. Students who attend school during economic boom times but have to repay their loans during economic busts could easily find themselves trying to service high-rate loans at the worst possible times. This, incidentally, is a big part of the problem now: Many students who took out loans at 8 percent or higher during the 1990s and 2000s are in repayment mode when interest rates are low and hiring is sluggish.

Ultimately, Obama's policies for college students and recent grads are proving to be a mixed bag. Pay As You Earn has the potential to completely transform the student loan landscape, effectively promising that the next generation of college graduates won't face the same Sisyphean economic task as the one the preceded it. On the other hand, the president's interest rate proposal risks undoing much of the good inherent in Pay As You Earn.

Either way, it won't really matter to young people recently arrived in the job market: Stuck with heavy loans at unserviceable rates, they're likely to remain out in the cold, trying to pay down their debt, without any real hope of escaping a brutal economic treadmill.

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Bruce Watson is DailyFinance's Savings editor. You can reach him by e-mail at bruce.watson@teamaol.com, or follow him on Twitter at @bruce1971.