Tuesday, June 7, 2011

Why student loans are the worst kind of debt

So much of the discussion on families in debt in the current economic crisis has focused on their mortgages, car loans, and credit cards.  But I am here to tell you that these are not the worst obligations plaguing American families in the US - student loans are.  Student loans are no longer the cheap debt they once were.  With mortgages at under 5%, the 6.8%, 7.9% or more charged by Federal or private lenders these days for student loans seems fairly pricey in comparison.  Here are five reasons that show that the silent threat to the American economy is not people's cravings for Gucci bags, McMansions, or Hummers but instead their blind devotion to financing outrageously expensive degrees.

  1. Student loan debt is huge.  The New York Times recently reported that student loan debt has surpassed credit card debt.  Pair this with their repeated stories of graduates struggling to make ends meet under the burden of their thousand bucks a month minimum payments and you know there's real cause for worry here.  The worst part is that the problem is only growing; the New York Times also reported predictions that student loan debt will surpass one trillion dollars ($1,000,000,000,000) this year. Of those who borrow for undergrad the average debt is $24,000 and growing.
  2. You can't sell or repo your education.  If you get in over your head with a fancy car or enormous house you can sell it.  Even if you're underwater on your mortgage or (even more likely) your car loan, selling at a loss will still reduce your debt burden.  You can also go through foreclosure and repossession which, while not fun or good for your credit, will wipe out your remaining debt for the item.  These are not an option when you're in over your head with student loans.  You can't sell your degree to someone else and you can't give it back to have part of your debt wiped out. Though one Boston College law student tried to do that in an open letter.  There is no collateral for a student loan so this debt is a debt pure and true without any offsetting asset with intrinsic value.  No, once you've made this purchase you're stuck with it.
  3. You can't get out of them with bankruptcy.  Unlike pretty much any other form of debt in the good old US of A, declaring bankruptcy does not normally wipe out your student loans.  Just think about all the scenarios where something can go really, really wrong with your finances.  Now think about the fact that in many cases no matter what that scenario is you will still have to pay your student loans each month or they will accrue interest, penalties, and fees leaving you with a lot more to pay off in the long run.
  4. They can sometimes last through death.  Check out this article from the Wall Street Journal about a family who is still paying off their dead child's student loans.  Can you imagine a more miserable situation?  If you co-sign a relative's student loans and the student passes away, the loans are still due.  You can be mourning the death of your child and still be responsible for making a large payment to Sallie Mae for their education that month.
  5. People think this is "good" debt.  There is an impression that student loan debt is a-okay because it's "good" debt. There are all sorts of rationalizations for this, you're making an investment, it's cheap money, it's the only way to get ahead, etc.  Families and students give themselves carte blanche to ring up an enormous student loan balance without really analyzing its benefits because they see student loans as harmless.  That makes their attitude really harmful.  With all the strings and costs and rules attached to student loans it's dangerous to think of them as anything but debt, pure and simple.  They are no more "good" than anything you buy with your credit card.  It's just another method of financing.  Sure, your education may be a great investment but your student loans are not.  Anything that's labeled with an APR instead of an APY isn't an investment and it's certainly not a good one.
I'm not saying that people should never take out student loans or that there isn't a place for them in financing your degree.  However, I am saying that students and families need to use more caution, perhaps extreme caution and prudence, in deciding if they want to take out these loans and how much they want to finance.

Similar thought and analysis should go to reviewing the degree program in the first place.  In some cases taking on student loans to get a degree pays off but in many cases it doesn't.  Can you guarantee that you'll be on the good side of that balance?

I can't.  I think getting my MBA is very likely to pay off but I am not so sure about it that I am willing to take out $100,000 in loans though it is commonplace, normal, "safe" and "good" debt in the eyes of my peers.   I just imagine the worst case scenario of being unable to find employment after graduation and being unable to find well paying employment long term. Do I really want to be saddled with ten years of $1,000 minimum payments on student loans in that scenario?  No thanks.  So for my degree I'll be trying to avoid them as much as possible.

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  1. Great points- I have a lot of friends who have heavily financed their degrees with student loans. It's one of those things that students don't think much about when they begin college because it's so common, but many rethink their decisions once they're trying to pay off $50k+ in debt (for private schools).

    Before reading this blog I assumed I would be taking out loans in the future for an MBA - after all it seemed like a good investment when looking at average salaries of those coming out from top programs. But you're right, student loans are never good and should be used as a very last resort.

    I'm hoping that if I save aggressively and apply for wide range of scholarships/grants I can complete my MBA debt free as well.

  2. Again, I think student debt can be "good" or "bad" depending on what institution you attend and what degree you receive. If you're attending graduate school at Harvard, where you'll network with a cohort of peers, alumni and professors who will introduce you to amazing opportunities, it could be well worth the investment.

  3. MoneyInYour20s - That's great to hear! I really feel that there's no harm in saving and shooting for schoarlships and trying to be debt free - the student loans will always be there to fill in the gaps, there will just be fewer of them (or maybe none!). Good luck!

    Paula - I think the degree from Harvard may be a good investment and degrees in general may be good or bad investments, but the student loans are only a method of financing. The student loans are never an investment in and of themselves and if they were they would be a terrible one since they have a negative return.

    Like a mortgage on a house, student loans can only reduce your return on investment since you will be paying significant interest on them eating into any gains you have. In some cases you may still be left with a positive ROI, but it will always be smaller than if you had paid with cash.

    The only benefits to student loans, buying on margin, and other debt is their ability to leverage what assets you have to provide greater opportunity. So while you may not be able to get the degree without student loans and obtain the maximum ROI you can still potentially use them to obtain the reduced ROI which is better than no ROI. Debt also allows you to minimize opportunity cost which can be helpful if you can pay for an asset in cash, but could gain a bigger return elsewhere (ie student loans are 7%, but you could get a %16 return elsewhere giving you an over simplified profit of 9% minus fees etc). The latter is not the case for most students, but the former might be if the degree is a good investment.

  4. Very well written. That stat noting how student-loan debt now surpasses credit card debt is shocking to me.

    But debt is debt. And making interest payments are never fun - no matter who you're paying.

  5. While I think that too much student loan debt or any student loan debt can turn into an ugly situation, I just can't agree that it's the "worst kind of debt." You take the interest right off the top of your gross income, they automatically defer payments if you go back to school (and pay the interest if it's a subsidized loan), and they are the easiest loans to defer.

  6. Good post, but I have to disagree with your comment about debt reducing ROI as opposed to cash financing. If the return on your degree (asset) is greater than the cost of debt, then your ROI actually increases due to the smaller initial investment.

    You have no assurances as to know much you will be making post-grad, but you can venture a guess. There is uncertainty involved, but uncertainty exists in stock market returns as well. If anything, your post-grad outcome falls more under your control than stock returns.

    If certain degrees are "outrageously expensive", then it's a stupid investment regardless of how you finance it.

  7. Student loans are almost non-dischargeable in bankruptcy. You still can have them discharged or eliminated. You just need to show to the bankruptcy court that the loan payments are putting an extreme burden on you or your family.

  8. I agree with the previous comments. Student loans can indeed give a lot of burden to the students. If you can't take it anymore, then you may need to get a help from your lawyer. He may advice you to file bankruptcy to get rid of the burden that makes your life more miserable. In fact, student loans are supposedly done for the benefits of the students.