Wednesday, April 25, 2007

Student Loans

A lot of people, including my own mother, have approached me recently to lecture me about the debt I currently hold. Of course, a majority of my debt is in federal student loans. The whole student loan industry has been in the media spotlight recently, with allegations of impropriety and other scandals. Why the uproar? Federal student loans are essentially government-subsidized loans.

Let me quickly explain that regardless of rather the loan is subsidized or unsubsidized (meaning interest is either paid by the government or accrued), the government is still providing a subsidy.

Consider the basics of a student loan. You are getting money to pay for an education that holds no value to the bank. Unlike an auto or house loan, if you default on the loan, the bank has nothing to repossess in order to get some of its money back. Typically, these loans are called personal loans, since the money has no particular use than for your own personal use.

Researching this type of loan online, the interest rate would be 13-14% if you had excellent credit. As a student, with little to no credit history, the rate could be much higher. Consider then that at the current 6.8%, you are getting at least a 6.2% discount on your loan(s).

You ask, "So what? The government gives me a better rate. Why shouldn't I pay it back anyway?"

Well consider this scenario:

You have $20K in cash. You owe $10K in student loans at 6.8%. You have no other liabilities. Let's also consider that you are considering buying a $20K car in the future.

Scenario 1:

You pay back the loans and borrow $10K for the car. Current auto loans are 6.9%. Simple interest a year is: $690

Scenario 2:

You keep the loans and use your cash for the car. Current student loans are 6.8%. Simple interest a year is $680.

Savings with the loans is $10 a year in interest alone. Now consider that this difference can be greater if (a) the loan amount is greater and (b) if the difference in interest rates were greater.

Finally, if you have bought everything you want, consider also there are investment opportunities for your cash. An average stock market return is about 8-10%, so keeping your student loan in place, you can make 8% in the market, pay the 6.8% on the student loans, and make 1.2% free!

1 comment:

Willster said...

One thing to think about is, if you take the example of neglecting your loans in favor of investing that money, the stock market has made an average of 8-10% over a large period of time, and would not necessarily do so within the time frame of your loans.

You can think of your debt as a sort of fixed rate CD. If you pay it off, you are basically guaranteed a fixed return on your "investment."

I agree with your judgment in the other cases, though, if you're only paying off one loan to replace it soon after with a loan at a higher rate, there's really no sense in it.