HELP is in need of help

Charging a higher real interest rate on HECS would hit the most disadvantaged the hardest. Shutterstock

An important issue for Australian university funding concerns the rate of interest applied to Higher Education Loan Program (HELP) debt. For the last 25 years the debts have been adjusted to inflation; this has ensured that the loan carries a zero real rate of interest for all debtors.

Times have changed. The 2014/15 budget proposes that the debt be adjusted to the long-term government bond rate, which would lead to significant inequities in the system. Bruce Chapman and I recently conducted some research on this issue, and found there are alternative indexation arrangements worth considering.

Is indexation fair?

The initial decision to charge at the rate of price inflation was to protect HELP debtors who experienced relatively low future incomes. Since relatively low-income borrowers will take longer to repay a given debt, members of this group are subsidised the most.

Our calculations found that under the proposed system of charging interest relative to the bond rate, a high-earning graduate with a debt of $60,000 would repay close to $75,000 in real terms (assuming a 5% bond rate). A low-earning graduate (but one who earns above the minimum repayment threshold) would repay as much as $30,000 more. If we consider a low earner who also takes 10 years off work to raise children, the repayments may rise by a further $10,000.

Why is this a problem? Consider a scenario where a teacher and finance student undertake different degrees but with the same fees charged. Is it fair that the teacher – whose salary prospects are lower than the finance graduate – will ultimately pay a higher real amount because of real indexation?

All income earners have the option to make greater repayments, and thereby reduce their interest charges. However, lower-income earners have lower capacities to repay than higher earners. In this sense bond indexation may be considered unfair.

But, if the student doesn’t repay the debt, the taxpayer does. Is it fair to ask taxpayers to pay the costs of interest rate subsidies made to low-earning graduates?

What are the alternatives?

Leaving aside the question of fairness, there is a question of incentives. Fee deregulation, the uncapping of what universities can charge students, already threatens to reduce participation in degrees with lower lifetime income prospects. This is exacerbated by bond rate indexation, which may pose not just a financial but also a psychological barrier, and dampen the ability of low-income earners to invest and finance other future liabilities.

It is worth considering, therefore, whether alternative indexation arrangements can mitigate some of these problems without posing an excessive budgetary cost. Under a hybrid arrangement, similar to that applied to the English system, loans could be indexed to inflation when debtors’ incomes are below the repayment threshold, and then to the bond rate when they earn over the repayment threshold.

This would reduce the risk that interest on the loan increases faster than loan repayments. An alternative could be a surcharge applied to the loan when it is first taken out, after which outstanding debt is indexed to inflation.

Both of these options would reduce the inequity associated with the bond rate. A surcharge results in identical real lifetime loan repayments for all borrowers (who repay their debts), whereas a hybrid arrangement would lower, though not eliminate, the differences between low-income and high-income earners.

What are the consequences?

When considering alternative policies, the behavioural implications or unintended consequences need to be considered. An advantage of real indexation is that the threat of compounding interest may provide greater incentives to repay HELP debt more quickly than if it were pegged to inflation.

While under a hybrid scheme this incentive is preserved for most income earners, it is not the case under a surcharge where the implicit interest rate is greater if the loan is repaid quickly. For example, under a 25% surcharge, if the loan is repaid in three years this is equivalent to an interest rate of close to 8% per year.

Further, a possible inefficiency from a fixed surcharge can arise if high-cost degrees tend to lead to higher incomes, and vice versa. For example, if degrees that produce lower-earning graduates (such as teaching) have lower fees, then a surcharge of, say, 25% would disadvantage these graduates compared to a hybrid indexation arrangement.

Loan interest is just one of many contentious issues. Despite the growing consensus that bond rate indexation arrangements should be changed, an unresolved matter is doubtful debt, which will increase markedly if tuition fee caps are removed. Some interesting proposals have been suggested (for example, collecting unpaid debt from deceased estates, shifting the costs of repayment shortfalls to universities, or imposing a lifetime borrowing limit for undergraduate students), but more discussion is needed.

In light of the uncertainty in behaviour, costs and affordability – for borrowers, institutions and taxpayers – a gradual approach to higher education policy change would seem prudent. Lifting the tuition fee cap, instead of removing it altogether, would provide some breathing room for institutions. It would also afford the government more time to gather additional evidence on how institutions and students react to higher fees.

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