American Student Loans: Repayment and Valuation

April, 2021

Abstract

American student loans are fixed-rate debt contracts that give borrowers the option to repay their balances in full by a fixed maturity, or to enroll in income-based schemes, whereby payments are proportional to their income above subsistence, and any balance remaining after several years of payments is forgiven but taxed as income. For a small loan, the cost-minimizing repayment strategy dictates maximum payments until full repayment, forgoing both income-based schemes and forgiveness. For a large loan, income-based repayment is optimal, either immediately or after a period of maximum payments. The critical balance depends on the loan rate, the tax rate, and the forgiveness horizon. Overall, income-based repayment significantly benefits large but not small borrowers.