Liquidity and Insurance in Student Loan Contracts: The Effects of Income-Driven Repayment on Default and Consumption

Enrollment in income-driven repayment (IDR) plans for student debt has tripled in the past five years, yet little is known of its effects on borrower welfare. IDR reduces monthly loan payments to a fixed portion of earnings until debt is repaid or some forgiveness period has been reached. By aligning the repayment burden with the returns to college, IDR may prevent default and improve financial well-being among credit-constrained borrowers but carries a potential cost to social welfare through moral hazard. In this paper, I estimate the causal impact of IDR on repayment rates, balances, homeownership, and consumption proxies using a novel dataset linking the first administrative panel of federal student loan payments to credit bureau records for over one million student borrowers. My research design uses two complementary identification strategies: a difference-in-differences design comparing borrowers with differential IDR take-up following delinquency calls from their loan servicer, and an instrumental variables design exploiting variation in the tendency of randomly-assigned servicing agents to enroll borrowers in IDR. I find evidence of liquidity benefits on both default and consumption margins. Within seven months of take up, IDR enrollees are 21 percentage points less likely to fall delinquent and pay down $90 more student debt each month compared to those who remain on standard repayment plans. IDR enrollees have credit scores that are 7.5 points higher, hold 0.1 more credit cards, and carry $240 higher credit card balances than non-enrollees one year after the servicing call, implying increased short-term consumption out of liquidity. IDR enrollees are also 2 percentage points more likely to hold a mortgage, an increase of 10 percent off of the pre-call mean, suggesting a positive effect of IDR on homeownership. Minimum monthly payments decrease by an average of $140 following IDR take up, but return to standard levels within one year of enrollment, minimizing the potential impact of moral hazard through loan forgiveness. My results suggest IDR improves borrower welfare by correcting for a market failure in human capital financing, allowing financially distressed graduates to borrow against future income when they lack the credit or collateral to do so through private lending markets. ∗Department of Economics, Princeton University, Louis A Simpson Building, Princeton, NJ 08544 (email: dherbst@princeton.edu, website: www.danjherbst.com). I am extremely thankful to my advisers Will Dobbie and Ilyana Kuziemko for their guidance on this project, as well as Leah Boustan, Henry Farber, Alan Krueger, David Lee, Alexandre Mas, and Christopher Neilson, who provided invaluable advice throughout its development. I also benefited from the helpful comments of David Arnold, Barbara Biasi, Felipe Goncalves, Steve Mello, David Price, Maria Micaela Sviatschi, and other Princeton seminar participants. Financial support was provided by the Princeton Industrial Relations Section and the National Academy of Education Spencer Dissertation Fellowship.