Why cutting student grants may have long-term financial implications for young graduates

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Students who apply for the Ontario Student Assistance Program this fall will find the grant portion of their funding – the part they don’t have to repay – has been cut to a maximum of 25 per cent from a maximum of 85 per cent. That means the amounts students owe could rise by thousands of dollars.

But in early March, Ottawa announced they were extending a temporary 40 per cent increase to non-repayable grants. So, we have two levels of government with opposite strategies.

Recent academic research suggests one of these paths could be a long-term mistake for young graduates, who are already facing a difficult financial landscape, from a challenging labour market to expensive housing.

A paper published earlier this year in the Journal of Finance considers the impact of reduced student debt on financial outcomes. The paper looks at a case where a private holder of U.S. student debt initiated lawsuits against tens of thousands of borrowers who were in default.

Many of these loans were discharged because, thanks to paperwork errors, the trust that owned the loans couldn’t prove who owed the money.

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National Collegiate Student Loan Trust, the largest private student loan holder in the U.S. with US$12-billion across 800,000 accounts, wasn’t the original lender. They purchased old loans from banks that were securitized by financing firms who bought them and bundled them into packages.

As these loans passed through multiple transactions, the documentation was corrupted. The proper “chain of title” for the debts could not be proved. In the end, thousands of debtors had their student debt discharged.

Because paperwork errors led to the relief from debt, it was as if the discharged student borrowers were chosen almost at random. This allowed the paper’s researchers to speak more to causality as opposed to just correlation.

Where it gets interesting is that the loan holders were in default and had already stopped making payments against their loans. That means discharging their debt did not directly increase the debtors’ monthly cash flow.

But the comparison also captures the fact that the control group – those whose paperwork were in order and didn’t get their debt discharged – did face the costs of default, such as having their wages garnished, which is a legal requirement for an employer to deduct owed amounts from an employees wages and send them to the creditor.

The debt discharges averaged US$7,901 per person and led to roughly US$3,000 more income over the following three years, a 12-per-cent decline in delinquency rates on other accounts such as credit cards and mortgages, and lower rates of bankruptcy and foreclosure. Discharged borrowers were also more likely to move cities, change employers and careers.

Why?

One likely mechanism is that borrowers who are facing aggressive debt recovery actions such as wage garnishment or debt collections feel like working harder mostly benefits the creditor. This is like the “debt overhang” concept in corporate finance: heavily indebted companies underinvest because creditors capture a lot of the upside.

What the authors of this research suggested is that the same mechanism may apply to individuals.

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The paper also suggests other forces are at work. Borrowers still facing active debt recovery stayed under financial pressure, while those who had their debts erased may have felt a huge mental burden lifted.

The authors point out that since they were looking at borrowers already in default, their findings may not apply to all student debt holders. However, it’s not a stretch to see that the debt overhang for the most financially distressed graduates could shape career and life decisions negatively.

And the most financially distressed graduates may correlate with those who enter postsecondary school with the greatest need for financial support.

The lesson for Canada is that different government approaches to student assistance lie in their respective budgeting frameworks and political philosophies.

Reasonable people can disagree about what governments can afford. What’s harder to argue with is where the cost ends up when they decide they can’t.

Preet Banerjee is the creator of YourMoneyDegree.com, a financial literacy program with an AI companion app.