Companies that collect student loan payments may have a financial incentive to stymie borrowers who wish to quickly repay their debts, a top federal regulator said Monday.
The barb, contained in a letter to the financial industry from Rohit Chopra, student loan ombudsman and assistant director at the Consumer Financial Protection Bureau, signals a growing trend toward increased government scrutiny of student loan specialists like Sallie Mae and publicized warnings that they may not be in compliance with federal law.
Chopra has publicly cautioned that servicers, or companies that deal with debtors and handle their student loan payments, may be cheating borrowers by not allowing them to apply excess payments to their private student loans that carry higher interest rates. Most borrowers have multiple loans -- for example, a different loan for each year of schooling -- with varying interest rates.
With interest rates near generational lows and refinancings scarce, borrowers seeking to reduce their debt burdens often attempt to pay down their most expensive debt. But according to Chopra, they’re frequently unsuccessful.
“Ironically, creating obstacles for borrowers to direct payments to a specific loan can increase future servicing revenue,” he said, noting the misaligned incentives between borrowers wishing to pay down their debts and the servicers that collect their payments.
Servicers, which are paid based on the amount of debt they’re collecting payments on and the amount of time it takes borrowers to repay their debt, may be violating federal law by hampering borrowers wishing to pay off their debts ahead of schedule, Chopra suggested.
Some 40 million borrowers carry $1.2 trillion in unpaid student loans, according to Education Department and CFPB data. Borrowers who graduated with bachelor’s degrees in 2012 left school with $29,400 in student debt on average. The Federal Reserve Bank of New York has said that borrowers are more likely to be delinquent on their student loans than any other consumer debt.
Regulators and other federal officials are worried student loan payments are reducing Americans' ability to spend, save, and invest, depressing economic growth. Economists have said that as student debt burdens have risen, younger borrowers with student debt have become less likely to purchase a home or a car.
It is against that backdrop that the CFPB has been probing how servicers are handling monthly payments. The consumer regulator says it has received complaints from borrowers whose efforts to repay their student loans have been blocked by servicers that do not honor their requests.
Chopra recently asked servicers how they process borrowers’ monthly payments when those payments exceed the minimum required. His letter this week summarized responses from six of them, whose identities were not revealed.
The results showed the companies are largely unable to honor borrowers’ requests to quickly pay down their debts by applying their extra payments to their most expensive loans.
Only four of the six servicers said they fulfill borrowers’ standing instructions to have their extra payments applied to their highest-rate loans. But absent such instructions, three companies said they do not apply extra payments to borrowers’ most expensive debt.
None of the companies said they proactively reach out to borrowers to ask how they want their payments applied, a finding that Chopra called "surprising."
Five of the six companies said they are not able to act on instructions borrowers submit when making big monthly payments through their banks’ online bill-pay platforms. Most also said they do not follow those instructions when payments are made by third parties, such as when the Department of Defense makes payments on behalf of active-duty service members receiving loan repayment assistance or when Congress pays portions of congressional aides’ student loan bills.
Several of the companies told the CFPB that they require borrowers to contact them after every extra payment if they want the money to be allocated to their loans in a specific way. “This ‘hassle factor’ may deter borrowers from providing instructions,” Chopra said.
Regulators are also concerned that servicers are using outdated or gaffe-prone technology that exposes borrowers to significant risk. Some servicers said they can’t modify their policies because their technology systems won’t allow for it.
But other companies have already responded to the CFPB’s pressure by adopting what Chopra called “borrower-friendly policies.” In these instances, servicers are now automatically applying excess payments to borrowers’ most expensive debt.
“For servicers that do not accept standing instructions or transparently communicate a simple prepayment method, this policy change may help servicers ensure compliance with the Truth-in-Lending Act's prohibition on private student loan prepayment penalties,” Chopra said.
Some took the comment as a veiled warning that companies may be violating the law if they hamper borrowers’ ability to quickly pay off their debts.
Sallie Mae, the nation's largest student loan servicer, is currently the focus of a federal investigation into how borrowers’ monthly payments are processed. Representatives did not respond to requests seeking comment.
The company recently told investors it expects to spend $70 million to deal with that and other probes into its business practices, prompting investors to dump its shares after it reported quarterly earnings on Jan. 16. Its shares have fallen about 20 percent since then, outpacing the roughly 5 percent decline in the Standard & Poor's 500 Index.
Chopra noted that when borrowers pay off their debts early, it hurts not only servicers, but investors in securities backed by student loans, due to the decrease in interest payments. Owners of so-called residual claims are at greater risk of losses if borrowers pay off their debts early, he said.
Sallie Mae is both an owner of residual claims on student loans as well as the servicer of that same debt, according to securities filings. The company recorded $312 million in gains off its sales of residual claims during the first nine months of last year, according to its most recent quarterly report.
The CFPB is concerned that the problems plaguing student loan servicing resemble the breakdowns that occurred in mortgage servicing in the aftermath of the financial crisis, such as so-called “robosigning,” when companies were found to have illegally signed off on foreclosure documents without properly reviewing them. Servicers that had a financial incentive to cheat borrowers with home loans were "one cause of significant harm to consumers in the mortgage servicing industry,” Chopra said.
The watchdog's focus on how servicers are allocating borrowers’ payments on their private student loans presents a challenge to the Department of Education, which oversees many of the companies that collect loan payments on its behalf.
Companies that service federal and private student loans often use the same systems, Chopra has noted, so it’s possible that many of the same payment allocation issues involving private student loans may be occurring in federal student loans. Some borrowers have complained that federal student loan servicers ignore their instructions.
The Education Department recently has come under fire for its alleged lack of supervision over its student loan servicers. Sen. Elizabeth Warren (D-Mass.) has said the department risks becoming a "lapdog" as a result of its lack of oversight.
The CFPB is soliciting borrowers’ complaints. The agency invited borrowers to submit complaints online or call a toll-free number: (855) 411-2372.