Saturday, November 2, 2013

Student Loans - Investment Or Liability?

This author will be the first to agree that an education is the best investment of time that anyone can undertake. Statistically, a college degree can increase ones income up to 75% over what it would be with only a high school education.

However, while in one sense time is money, the money spent for an education is not an investment, most especially when using debt to pay for it. Anytime I've had to repay an investment with the toils of labor, I've thought of it as a loss.

The greatest problems with student loans are the "mixed" metaphors that are thrown around, an overall lack of understanding of investments and the Rule of 72. Simply put, an investment is when something is purchased and the purchase provides a return. For example: you purchase a stock for $100.00/share and it provides a dividend of $7.00/share/year; you have a 7% return realized each year - your money is working for you.

The Rule of 72 is used to calculate the estimated time it takes to double an investment. What makes it interesting with respect to student loans is that it can also tell you how many times you will double the principle while you repay your loans. If you have an interest rate of 6% you take 72 / 6 = 12 years, so money invested at 6% doubles every 12 years or a loan repaid over 12 years at 6% interest effectively doubles the original amount borrowed e.g. a $10,000 loan repaid over 12 years will require $20,000 in total payments.

What keeps an education loan from being an "investment" when it comes to education is that YOU are working hours to repay the loans vs your MONEY, in this case the loans, working for you and repaying the debt. This effectively makes the education debt a liability, in more ways than one would like to think, while going to school and after.

Another detail left out, and foreign to many parents is that student loans are NOT your typical installment loan, but rather commercial loans. Most parents, and many students, are familiar with auto loans, where if you make your payments on time, you pay an amortized interest rate and some principal each month. On a commercial loan, and student loans, the interest is calculated upon the receipt of each payment and any remainder is then applied to principal. This means two things: first it is possible to have no principal reduction in any given month with the entire payment going to interest only and second it is imperative the payments are posted to your account on the same day each month, or more ideally once every 28 days - so you can achieve principal reduction.

The last detail most students and parents seem to overlook is the amount of loans versus the likely starting income for the selected career. It has never ceased to amaze how, in this information age, a person can have no idea what kind of income they can expect upon graduation. This point is critical because it will determine whether the future graduate will have a life or move back in with Mom and Dad so they can repay the loans. For a quick thumbnail sketch, for every $10,000 borrowed at 6% for a period of 10 years, the student will have a payment of approximately $111/mo. If a student has borrowed $30,000 (the average is approximately $21,000) their payment would be $333/mo. In 2008, the average starting salary for liberal arts students was $32,000; for business and technical degrees $45 - 50,000. While the incomes sound high, many students are in higher tax brackets early on. If you add rent, utilities, car and insurance payments, along with food, the student with a high student loan debt is quickly buried.

If you have to borrow to obtain an education, proceed with great caution, read everything carefully and have a plan from the start. Consult with a financial professional to better understand the payments and terms, don't depend on the school counselors as many are little more than sales people trying to fill the classrooms. Prepare for delays after graduation in finding a job. All students should check sites like FastWeb for grants and scholarships, apply to anything they even remotely qualify for and don't give up. Grants and scholarships require no repayment. Students should also start, in the first semester of their sophomore year, applying for internships, many of which pay and will further reduce the need for loans.

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