The student loan debt “crisis” has been making headlines across the country and drawing strong responses from all the major presidential candidates. There is a lot of discussion about making college free, forgiving student debt, or providing federal refinance programs. At the same time, there are horror stories about folks who have mountains of student debt that they don’t see how they can pay off. Against this backdrop, prospective college students need to make complicated financial decisions in the next few months about how to pay for college. For some students, who are still teenagers, these questions may seem daunting. Perhaps some general guidelines about education finance would be helpful.
First, taking on debt requires careful consideration, mature planning, and is not always appropriate. Credit is ubiquitous in our society. According to the Federal Reserve, total consumer debt in America is over $3,500,000,000,000 – that’s TRILLION! – and this excludes mortgage debt. Debt generally falls into two categories: secured and unsecured. Secured debt means money borrowed to finance the purchase of an asset that has a long life span, such as a home or a car. It is “secured” because the lender can take the asset if the borrower doesn’t pay back the debt. Think about the foreclosure on a home or repossession on a car and you have the right idea. Unsecured debt is backed only by the borrower’s willingness and ability to pay.
Student debt is a bit of a hybrid. While no lender can “repossess” your education, you are in fact financing a long term asset, i.e. your education. It might seem odd to consider your education an “asset” like a car or a home. But in a way it is, since your education is the means by which you will achieve your livelihood, hopefully for many decades.
Certainly, there is much more to getting an education than securing future income. There is the community you will join, the relationships you will build, the books you will read, and the teachers who will mentor and guide you. But, at the same time, you may spend tens, maybe hundreds, of thousands of dollars. Is it reasonable to borrow some of that?
Cold hard math would suggest that it is. Many studies have shown that college graduates earn more – much more – than those who lack a college degree. And this earnings disparity is likely to persist over many decades. Suppose one were to borrow $50,000 to earn a college degree and, as a result, increase one’s future earnings by $30,000 per year for the rest of one’s working life. These are not fanciful assumptions; they are actually supported by recent studies from the Economic Policy Institute showing college graduates earn nearly twice as much as high school graduates. Assuming a 30-year working career, that $50,000 investment would be repaid many times over. In strictly financial terms that would be perhaps the best investment one could ever make.
But some education investments are not quite so good, and students should also consider the potential downside. Suppose one were to borrow $50,000 and not graduate. Not only is there the cost of foregone income while in school but also the dismal prospect of not earning any more than one would have earned without the college interlude. Here it’s easy to see that the $50,000 in debt can potentially leave one worse off. The question is, how do you decide?
Most students are optimistic, and it’s always a good idea to “bet on yourself.” But there are better and worse ways to bet on oneself. The key is having enough information to make the most informed choice you can. The Obama Administration has recently introduced a College Scorecard, which provides school-by-school information about graduation rates and post-graduate income levels. Such tools are invaluable in providing the information necessary for students to make informed choices. A number of studies have improved upon the scorecard and looked at various colleges’ “value added.” They attempt to answer the question, How much more does a student earn by going to one college versus another? This approach is an improvement on the “college or no college” framework. It uses real data to determine which colleges provide better returns on investment – or “return on education.” The Economist magazine has a very helpful calculator that looks at these sorts of economic returns to education.
So does it make sense to finance a part of your college education with borrowings? One should always be careful when borrowing, especially since education debt is not likely to be forgiven, even if the student goes bankrupt. But while a college education is more than a financial decision, it is not less than one. If you are confident that the degree you will receive will lead to lifetime earnings power well in excess of what you might earn without the degree, then some amount of debt is justified. But be realistic about post-graduation debt and income levels.
At College Ave, we try to make the first part as transparent as possible, and our calculator tool gives you the information you need to determine monthly payments at various debt levels. The income projections are available from a variety of sources such as the one linked above. Before borrowing, make sure you have a reasonable prospect of earning enough income that you will be able to repay the debt easily, not using much more than 15-20% of your after-tax income on debt repayment. As an example, a student who borrows $50,000 for four years of college at 7% for a 10-year term would have monthly payments of just under $600. If the graduate is now earning $40,000 per year after taxes, the loan payments would take about 17% of the post-tax income. Students should think ahead about reasonable budgets and only borrow if the math makes sense.
A college education is still part of the American Dream, and it might make sense to finance that dream – just be sure to do the math first!