U.S. banks should reduce default risk by helping borrowers challenged by repayment of private student loans to come up with alternative payment plans, a Federal Reserve official said.

Making changes to such plans is usually in the interest of both bank and borrower, leading to “better loan performance, increased recoveries, and reduced credit risk,” Todd Vermilyea, a senior associate director in the Fed’s Division of Banking Supervision and Regulation, said in testimony prepared for delivery Tuesday to the Senate Banking Committee.

“Federal Reserve examiners will not criticize institutions that engage in prudent loan modifications, but rather will view such modifications as a positive action when they mitigate credit risk,” Vermilyea said in remarks for a hearing on private student loan regulation. “Our goal is to make sure that lenders work with borrowers having temporary difficulties.”

Lawmakers and regulators are increasing scrutiny of the $1.2 trillion in outstanding student debt. Amid declining post- recession household wealth, total borrowing has climbed as the cost of higher education and total enrollment rise. About 21 percent of student loans in repayment are delinquent at least three months, compared with a 6.3 percent delinquency rate in 2004, according to Vermilyea.

Federal loans account for about 85 percent of the total student debt, Vermilyea said. Officials from the Consumer Financial Protection Bureau, Office of the Comptroller of the Currency and Federal Deposit Insurance Corporation also are scheduled to testify tomorrow.

Sustainable Repayment

The Fed encourages lenders to create “sustainable repayment plans while also preserving the safety and soundness of the lending institutions,” Vermilyea said.

Unmanageable student debt may have a broader impact on the economy and society, according to written testimony prepared by Rohit Chopra, student loan ombudsman with the CFPB. Among 28,000 responses from borrowers and experts sent to the CFPB about student loans, writers discussed challenges for homeownership, business starts and retirement.

The share of 25-year-olds with student debt increased to 43 percent last year from 25 percent in 2003. The average education-loan balance among that age group grew by 91 percent over the period, to $20,326 from $10,649, according to the Federal Reserve Bank of New York.

Borrowers challenged by federal student loan repayment may qualify for modification through programs such as income-based repayment.