Today in a few of the news reports I listened to some testimony on student loan debt and the impact it has on young people trying to start their lives. The news article spoke of a woman with a teaching degree who racked up $60,000 in debt. Another woman spoke about how she had paid on her loans for 8 years and would need to continue to pay for another 25 more years before they were fully repaid. She complained that this would affect her ability to save for retirement.
The sad thing about student loan debt is that it doesn’t need to be this way. It is very predictable and very preventable. It is all about the choices that are made. For some reason people are bad at saving for things that are very predictable, but a long way off and that seem insurmountable.
When it comes to things like college, medical care in old age, and retirement home people therefore save little or nothing. There is also a sense that they should get those things for “free” because, how could they ever pay for them? For this reason families with the latest cell phones, new cars every couple of years, cable TV with hundreds of channels who have taken extensive domestic and international vacations each year end up with children of college age with no money to pay for college saved. In some cases they may think that if they do save up they’ll not get financial aid while their neighbor, who saved nothing, gets a free ride. Some therefore purposely don’t save to maximize the financial aid they receive. (Isn’t it odd that most people wouldn’t spend their grocery money in hopes that they could then get a free meal at the food bank, but most people don’t save for college so that they’ll get financial aid, another charity program? Newspapers and Money Magazine even give tips for middle and upper-middle class families on how to maximize what you get in financial aid.
Many families discover that they don’t get the financial aid they expect. They then end up having their children take out student loans (and sometimes take out loans themselves) to pay for college.
Another bad choice made by families who can’t afford to pay for college is the choice of college. Normally families who can’t afford something and need to borrow will choose the least expensive option. And yet many students taking out loans don’t choose an inexpensive college or look at options to reduce costs like spending a couple of years at a community college. They instead go straight into the expensive, private schools and get a nice apartment, also paid for with student loans. Instead of rushing through college, taking as many classes as they can since the price is the same after 12 hours, they take a minimal number of classes and take five or six years to graduate, increasing the amount of their debt.
They also don’t consider the amount of the loans they’re taking out and the chances they will be able to pay back the loan with the careers that they are choosing. After then racking up loads of debt, they complain that their loan payments are so high compared to their salaries that they can’t do other things like buy a house (or move out of their parent’s house) because of their loans. Shouldn’t someone in a career path with a $35,000 starting salary realize that $100,000 in loans is unreasonable?
Some blame a lack of understanding of what they’re getting into. Others just blame a lack of financial education. I think it is a combination of poor financial literacy and just general hope and denial. Parents hope they will somehow be able to pay for college for their children (or, more precisely, their children will be able to go to college without them paying much) but don’t save and invest, even though they know the expense is coming. You can pretty much predict a child will want to go to college when they are about 18, so it isn’t like it is a big surprise. And you have 18 years to prepare!
The students in college then just keep taking out more and more loans because they don’t realize the effect of interest and also because they choose to not think about it.
For those with poor financial literacy, here are some guidelines:
- You will pay a lot more in interest when you start to pay off a loan than you will when the loan is nearly repaid, assuming equal payments. This means that the loan value will not reduce by much during the for ten years on a 30 year loan and it will take over 20 years to reduce the loan balance by half.
- The amount you pay in interest will double every N years, where N is 71 divided by the interest rate. This means that if you have a 4% loan and take 20 years to pay it off, you will have paid two times the amount you would have paid if you just paid cash in the first place.
- If you take out your salary in student loans (e.g., you make $50,000 per year and have $50,000 in debt) and then pay 10% of your salary towards the loan each year, it will take you about 15 years to pay back the loan. If you take out less than 30% of your future salary out in a loan, you can easily pay back the loan in about a year for about the cost of a reasonable house payment (note, this requires living at home rent free. You can do it in about 2 years if you rent a modest place while you’re paying off the loan).
- The more you pay early in the loan, the more you’ll save in interest. Pay an extra 10% on a 30 year loan and you’ll cut a full payment off of your loan.
It even works better if you put interest on your side instead of fighting against it. If parents would start putting away about $120 per month per child into a tax-free college savings plan like an educational IRA from the time the children were born, and invest the money in stock mutual funds and shift into CDs and money markets as they start to approach college age, they will have around $80,000-$100,000 per child for college when the child turned 18. This would be plenty of money to put a child through college in most cases.
So, you can choose to hope to afford college and end up saddling your children with student loans. Your children will then pay $800 per month for 30 years (and stay in your basement with their spouse and children). Alternatively, you can instead pay $120 per month for about 15 years and start your children out debt free. Which sounds better to you?
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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.
