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Privatizing Federal Student Loans: Estimating the Costs of Simplification
By Mike Surace
Background
The Trump administration aims to cut government spending, including scaling back the federal government’s role in financing higher education. Recently, President Trump signed an Executive Order to dismantle the Department of Education (ED) and announced that the Small Business Administration (SBA) would assume responsibility for administering ED’s $1.5 trillion student loan portfolio serving 38 million borrowers.
While these actions are a dramatic signal, transferring ED’s portfolio to another federal agency—whether SBA, Treasury, or elsewhere— will not reduce the government’s student lending footprint. To reduce today’s book, the government needs to relinquish loan servicing responsibilities, repayment risk, or both, in a way that protects the taxpayer and upholds obligations to counterparties.
In principle, the most direct way to shed operating costs and credit exposure is to sell the student loan portfolio in the market. In practice, the complexity of the program’s loan servicing options presents a major hurdle—primarily, the borrower’s ability to switch repayment plans and, in particular, their option to enroll in Income Driven Repayment (IDR) plans.
Plan switching. Borrowers entering repayment select an initial repayment plan—e.g. standard, graduated, extended, or IDR— and have the option to switch plans anytime thereafter subject to eligibility constraints. Plan switching impacts cash flows as different repayment plans lead to different monthly payment amounts. Plan switching provides borrowers with benefits analogous to those of an insurance policy. The option to switch into IDR protects borrowers against the risk of default during periods of diminished income. The option to switch from IDR back into a non-IDR plan serves as a payment cap during higher-income periods.
IDR. There are multiple types of IDR plans in the student loan portfolio, including Income Contingent Repayment (ICR), Income Based Repayment (IBR), Saving on a Valuable Education (SAVE), and Pay as Your Earne (PAYE). They pose a unique challenge to servicing and valuation. While payment schedules under standard, graduated, and extended plans are predefined, a borrower’s required monthly payment amount under IDR fluctuates based on discretionary income and family size. IDR can also extend the standard 10-year student loan term to 20-25 years and forgives any remaining balance at term. Loans that employ or have the option to employ IDR are much harder to service than typical consumer loans and much more difficult to value. IDR not only requires a servicer to collect and verify additional data elements and periodically recalculate payment schedules—it also makes for significant uncertainty around future cash flows[1]. The former challenges private sector entities’ loan servicing models; the latter results in a wide dispersion in potential valuations, making it difficult for the government and a private buyer to agree on a sale price.
To transition the portfolio to the private sector, the government would need to simplify it by removing IDR as an option and converting existing IDR loans to traditional repayment schedules. Since IDR is generally considered a right for existing borrowers, the government would likely need to compensate borrowers to relinquish it.
In this post, we provide a framework to estimate the value of the inducement required to “buy out” borrowers from IDR plans.[2] This framework could be implemented to determine whether the policy approach is feasible, to support development of a buy-out policy, inform implementation strategy, and structure buy-out terms with borrowers. Buy-outs could be implemented through principal balance reductions, note rate reductions, maturity extension, cash payment, or other means; whatever method chosen would likely incur a budgetary cost.
A general framework for valuing buy-outs
All else equal, borrowers should be willing to accept changes in their loan terms if the net present value (NPV) of repayment cash flows under the new terms, including any buy-out amount, is favorable relative to their existing terms. For loans that include a borrower option, such as plan-switching, the option value must also be included. A general formula to represent this relationship is:
Buy-out >= [NPV of Cash Flows]Existing + [Option Value]Existing – [NPV of Cash Flows]New
Applying the framework to estimate IDR buy-out costs
To estimate the buy-out required to remove IDR as a repayment option, we apply the framework to two groups of borrowers:
(1) For the approximately 12 million borrowers currently enrolled in an IDR plan, the buy-out amount needs to compensate for the difference between the NPV of expected repayments under IDR and the NPV of scheduled repayments under the new loan terms, plus the value to the borrower of the option to switch into a regular (non-IDR) repayment plan in any future period:
Buy-out >= [NPV of Cash Flows]IDR + [Option Value]Plan-Switching – [NPV of Cash Flows]New
(2) Borrowers currently in a regular (non-IDR) repayment plan have the right to opt into IDR at any time. For this group, the buy-out amount must compensate for the difference in the NPV of expected repayments under the existing and new loan terms, plus the value to the borrower of the option to switch to IDR in any future period.
Buy-out >= [NPV of Cash Flows]Non-IDR + [Option Value]Plan-Switching – [NPV of Cash Flows]New
Calculating repayment cash flows for non-IDR plans ([NPV of Cash Flows]Non-IDR) is straightforward given basic loan information. Estimating repayment cash flows for IDR ([NPV of Cash Flows]IDR) and the value of the plan-switching option ([Option Value]Plan-Switching) is more challenging.
Estimating [NPV of Cash Flows] IDR
Estimating future cash flows for loans in IDR is inherently complex as the payment schedule is calculated based on borrower income and family size, both of which can fluctuate over time. While difficult, this forecasting is not intractable. Several approaches exist, including within ED, that could be leveraged or extended. Research in the field has correlated income and family size with demographic variables like educational attainment, age, job history, and marital status, as well as economic conditions. In addition, the current administration’s moves towards greater interagency data-sharing could expand access to previously inaccessible but essential data elements such as borrower income histories from the IRS.
Estimating [Option Value] Plan-Switching
For any point in time, the value to the borrower of the plan-switching option can be calculated based on the aggregate probability of selecting a particular plan in each future period t and the selected plan’s relative NPV-of-cash-flows advantage over an alternative plan as of that future period. For example, for a loan currently in a non-IDR plan:
Where is the probability of the loan/borrower selecting an IDR plan in period . Plan selection probabilities can be specified using a general linear model such as: 
Where Pt(j) is the probability of a loan being enrolled in repayment option j in period t, loant represents the loan characteristics, demogt represents the borrower’s demographic characteristics, dt-1 is a dummy indicating which loan option was chosen in the prior period, dxt is the number of previous periods in which each loan option was chosen, and NPVjt is the net present value of loan payments for a particular plan and time period. The betas can be estimated using data on observed repayment-plan selections.
Additional Considerations for Valuation
Factors beyond those in the framework we’ve presented can impact the amount required to buy borrowers out, by making certain options more or less attractive than the NPV-of-cash-flows approach alone would indicate. These factors can be separately estimated and added to the analysis. For example:
- Liquidity. When borrowers are evaluating different repayment options, the amount of the monthly payment is a key consideration. Beyond the question of affordability, borrowers put different values on liquidity. Some borrowers will select plans with higher monthly payments to pay down their loan faster and with less total interest. Some borrowers will select plans to reduce their monthly payment, even if it leads to paying more interest over time.
- Insurance value. The IDR option provides borrowers with protection against default. Individual borrowers have different levels of risk aversion and so will place different values on the option’s insurance value.
- Other indirect factors. There may be additional economic and non-economic factors that may influence a borrower’s decision to renegotiate their loan. For example, emerging with a smaller loan balance, such as what might be offered under a simplified repayment plan, can provide auxiliary benefits such as an increased credit score.
Conclusion
The complexity of repayment options in the $1.5 trillion federal direct student loan portfolio restricts servicing to a small group of specialized contractors and inhibits the participation of private capital. Buying borrowers out of IDR would simplify the portfolio greatly, making private investment more attainable and reducing the cost of servicing. Policymakers who want to reduce the government’s student lending footprint should evaluate portfolio simplification as a key first step.
[1] Per the FY 2025 Federal Credit Supplement (released in March 2024), ED’s cost estimate for loans made since 2010 has increased by over $225 billion dollars relative to initial estimates. A majority of this increase was attributable to underestimated IDR costs.
[2] While this framework is geared to IDR plans, the overall concept can be applied to other student loan servicing options and other government portfolios with special servicing features for example mortgage payment assistance, interest rate subsidies, and loan deferments.
