When you don’t have the money to buy something, you either borrow or you do without. So what are the factors that determine whether it’s best to borrow or do without?
Through the history of finance, the consensus has been that borrowing to increase wealth is a worthwhile endeavor, while borrowing for leisure or consumption is unwise. The basic assumption behind “good borrowing” is that the financial gain one hopes to achieve from using borrowed capital will result in greater prosperity – even after the debt has been repaid. This paradigm of borrowing to increase prosperity is the essence of “good” banking, in that both the borrowers and lenders are better off. (In contrast, when consumers incur debt for leisure or consumption, the profitability of these transactions heavily favors lenders; borrowers may realize some immediate enjoyment, but often end up poorer.)
Figure 1
One of the concerns with borrowing, in any context, is that a borrower may take on so much debt that it becomes impossible to repay it. For countries, businesses or individuals, an out-of-whack debt situation is a financial death spiral in which the likely result or outcome is default and bankruptcy – outcomes that hurt both borrowers and lenders. For this reason, borrowers and lenders have strong incentives to monitor debt ratios.
Student Loans: Good Borrowing Gone Bad
For at least the last half-century, borrowing to obtain a higher education has been seen as good borrowing, because of the assumption (strongly supported by statistical evidence) that a degree will lead to higher income and greater financial opportunity. But too much debt or not enough earnings can undo the good idea of borrowing for a college education. And today, the numbers and anecdotal evidence strongly suggest that the fundamentals of educational borrowing are trending toward trouble.
First, there is the fact that education-related debt is mushrooming:
- Late last year, the Federal Reserve reported that Americans now owe more than $1 trillion in student loans, exceeding what is owed on credit cards and automobiles.
- An October 18, 2011, article in USA Today noted that outstanding debt has doubled in the past five years.
- The College Board reports that, adjusting for inflation, students are borrowing twice what they did a decade ago.
- In 2010, the Project on Student Debt found that two-thirds of college students needed student loans, and their average loan balance was $25,500.
Not surprisingly, the increase in borrowing has meant an increase in payments due after graduation:
- The Bureau of Labor Statistics says average loan payments have risen 83% over the past decade.
- Stories in the Chicago Tribune, Wall Street Journal and Detroit News featured graduates whose monthly student loan repayments comprised 40 to 60% of the graduates’ take-home pay.
Adding to the problem of larger balances: less work, more defaults.
- The April 18, 2012, Wall Street Journal said “The unemployment rate for young college graduates rose from 8.7% in 2009 to 9.1% in 2010, the highest annual rate on record.”
- The April 17, 2012, Detroit News quoted a New York Federal Reserve article stating 27% of active student loan balances are 30 or more days past due.
Suddenly, student loan debt is becoming a national issue, generating provocative sound bites:
- Chicago Tribune reporter Becky Yerak leads off with, “Move over, mortgages. Get out of the way, Greece. Another economic doomsday scenario is emerging.”
- In the USA Today article, Nick Pardini, a Villanova grad student in finance, warns student loan debt is “going to create a generation of wage slavery.”
- Illinois Attorney General Lisa Madigan testified before a U.S. Senate subcommittee in March 2012 that, “Just as the housing crisis has trapped millions of borrowers in mortgages that are underwater, student debt could very well prevent millions of Americans from fully participating in the economy or ever achieving financial security.”
These comments reflect concerns that an out-of-balance student loan situation has become severe enough to impact the national economy. Slate writer David Indiviglio notes the U.S. government now holds almost half of all student loan debt; defaults would mean “taxpayers are on the hook again…and it puts U.S. higher education in the embarrassing position of hindering, rather than helping to fuel, economic growth.”
The potential impact isn’t just national and financial; it’s personal, and it spills over into other areas of life. Graduates say that the burden of student loan debt forces them to defer marriage and children, prevents them from qualifying for a mortgage, limits their access to credit cards or car loans, and restricts their opportunities for post-graduate education that might significantly increase their earnings.
In some cases, student loan debt is so great that graduates face the prospect of never getting out from under it – the loans will be a lifelong economic barrier to prosperity.
Why College Borrowing is Out-of-Balance
Considering the context in which these life-altering decisions are made, it shouldn’t be surprising that borrowing for a higher education is creating a potential financial crisis.
On a macro level, college expenses have been rising faster than the cost of living for the past three decades (see Figure 1 on page 1).
This means paying for a college education requires a
larger percentage of household income.
At the same time, while a college degree generally results in much higher earnings compared to individuals with a high school diploma, the rate of real income growth is actually declining for young college graduates. Writing in a March 2, 2012 New York Times op-ed, Tyler Cowen, a professor of economics at George Mason University, noted that “Real earnings for men, [ages] 25 to 34, with bachelor’s degrees are down 19% since 2000, and for female college graduates of that age they are down 16% since 2003.” (See Figures 2 and 3.)
And yet, Cowen also notes that not having a college degree today has even greater negative impact on earnings: “Thirty years ago, college graduates made 40% more than high school graduates, but now the gap is about 83%.” In summary, it costs more to get a college education, but it costs even more to go without one. In this damned-if-you-do-damned-if-you-don’t environment, it’s easy to see how the math of student loan debt could turn ugly.
Figure 2
Figure 3
Add to these macro issues the personal challenges in figuring out college funding. Few 18- or 19-year-olds have an accurate idea of what they want to study or the career they want to pursue. The norm is changing majors, sometimes changing schools, taking longer than four years to finish – then taking several years to settle in a profession. Change and
uncertainty in any endeavor make it hard to plan for the future; it’s even tougher when, for many, paying for college is their first encounter with long-term financial decision-making.
And studies indicate both parents and their children are ill-informed about their borrowing options. Sue Shellenbarger, writing in the April 18, 2012,Wall Street Journal, says “Most students get little help from colleges in choosing loans or calculating payments.” Deanne Loonin, an attorney for the National Consumer Law Center, finds many borrowers “are very confused, and don’t have a sense of what they’ve taken on.”
Given these factors, it’s easy to see how student loan debt can put many graduates behind before they ever get started, and how difficult it can be to undo poor planning.
Fixing the Funding Dilemma
Most of the top-down proposals coming from legislators and education advocates regarding student loan issues are tweaks to the existing system. There are proposals to limit loan payments to a percentage of income, relax the qualifications for forbearance, and expand the criteria for loan forgiveness. However, each change that lowers payments or reduces balances also increases the probability that lenders will either charge more or tighten their qualifications. These ideas, while well-intentioned, aren’t going to be game-changers, which means parents and prospective students need to find other ways to get a degree without going broke.
Given this information, a simple response is rearranging priorities to save more money. If a college education is integral to your children’s future, paying for it has to become a high-priority financial objective – maybe even more important than retirement (for awhile). Every tuition dollar that isn’t borrowed delivers big returns down the road. Consequently, a thorough review of current allocations and accumulation strategies may be in order.
Another fundamental action is becoming informed. Several experts stated most borrowers aren’t aware of the differences between government loans and private loans. And while the evidence is mostly anecdotal, scholarships go unfilled each year. For those who have time to prepare, knowing the pros and cons of Coverdell and 529 plans, UGMA accounts, and how eligible assets are reported on the FAFSA form can be invaluable in receiving grants and other types of financial aid.
A practical consideration is to start slowly, and stay local. Attending a community college for a few years may dramatically reduce tuition costs, buy time to carefully consider a career path and allow for some financial life experience (like paying rent or following a budget).
Look for innovative market solutions. More than ever, a college education seems essential to long-term career and financial success. But the current student loan paradigm as a way to obtain a college education is not sustainable. The need for a “work-around” to the current funding paradigm is a huge entrepreneurial opportunity to make college education more affordable. There are rumblings that on-line classroom formats are poised to revolutionize the delivery of higher education. And some employers (such as the military services) subsidize or reimburse higher education expenses for their employees; this practice could expand. Finding entry-level employment with a company that offers an “earn and learn” program could be a huge funding source.
Set a limit on debt, and agonize over exceeding it. Just because a lender is willing to give you more money doesn’t mean you will be able to pay it back. Earning a degree while accumulating too much debt is a recipe for financial failure. Many of the personal stories accompanying articles about student loan debt feature people who “had no idea my payments would be this big” after graduation. Their thought process was “don’t worry about it, just focus on your studies. You can work out the details once you find a job.” Regardless of the topic, that’s no way to make an informed financial decision!
If people have the aptitude, they should make every effort to get a higher education, because earning a college degree has a strong positive correlation for a broad range of financial and personal well-being factors. But a poorly considered borrowing plan has the potential to negate these advantages by shackling graduates to an anchor of long-term debt. Understanding what’s at stake, it should be clear that deciding to borrow for college is a project that requires thorough examination and careful deliberation. In the current financial environment, these are decisions that have a tremendous lifetime impact.
- SERIOUS ABOUT COLLEGE FUNDING?
- GET INFORMED, GET ASSISTANCE,
AND GET STARTED!
Joe Capone, LUTCF
Financial Advisor, Park Avenue Securities
OmniMed Financial & Insurance, Owner
140 Kendrick Street, C-1 East, Needham, MA02494
Office: 781-292-3285 / Cell: 781-264-1234 / Fax: 781-449-4462
joe_capone@omnimedfinancial.com / www.omnimedfinancial.com
Joseph Capone is a Representative and a Financial Advisor of Park Avenue Securities LLC (PAS) and a Financial Representative of The Guardian Life Insurance Company of America, New York, NY. Securities products/services and advisory services offered through PAS, a registered broker-dealer and investment advisor. OmniMed Financial & Insurance is not an affiliate or subsidiary of PAS. Life/Disability/Long Term Care insurance offered through OmniMed Financial & Insurance. OmniMed Financial is not licensed to sell insurance. Neither Guardian, nor its subsidiaries, agents or employees provide tax or legal advice. You should consult your tax or legal advisor regarding your individual situation.
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