April 23, 2014

Mail Bag: Should I Take Out Student Loans to Invest?

One of the single most common questions I receive from friends, family, and readers who are enrolled in college is, “Should I take out student loans and invest the excess above and beyond the cost of college?”  No doubt spurred by the historically low rates – the interest expense on a typical government student loan is lower at the moment than the dividend yield on high quality blue chip stocks – the topic brings up a host of financial considerations.

The General Answer to, “Should I Take Out Student Loans to Invest?” Is a Resounding “No”

There are several problems with using student loan debt to fund investments:

  • Student loans are often taken at a time in life when your household income and assets are low relative to your later, working years.  This makes student loans inherently riskier than other forms of debt.
  • Due to changes in the bankruptcy law, it is very difficult to discharge student loans in bankruptcy court.  That means they could be a millstone around your neck for the rest of your life, creating the 21st-century equivalent of a debt slave.  The law change, which occurred during the administration of George W. Bush, is one of the most egregious examples of government misuse of power in history.  It created a specialized class of debt, guaranteeing profits for banks, who essentially bought the legislation with their lobbyists.
  • Most people are terrible investors.  We have spoken a great deal about the Morningstar study that showed investors earned, at best 2% to 3% during time periods when their underlying investments generated 9% to 10% returns because of their frequent buying and selling.  The average man or woman isn’t emotionally equipped to generate profits on their money.

That is the risk.  Imagine you borrow $10,000 in student loans, put it in the stock market, and lose it all.  Now you have student loan debt that must be repaid, you have to cover interest expense above and beyond the principal, and you can’t discharge it in bankruptcy if something goes horrifically wrong.  

Federal Stafford Student Loan Debt Promissory Note

When you borrow money, you are renting someone else's savings. The problem? Student loan debts have special provisions that make them nearly impossible to escape if something goes wrong.

Additionally, I’ve made it clear in the past that, short of those who suffer significant, unexpected medical problems or catastrophic economic events, I’m not a big fan of people complaining about drowning in student loan debt.  I watched first hand how some of my classmates borrowed $100,000+ at 8.5% or higher and then acted surprised – genuine, shock – when they didn’t see their principal reduce after years of working.  “How can it be?  My payments are over $1,000 a month!” they would exclaim.  

These are people with college degrees.  We learned in fourth grade that 8.5% on $100,000 is $8,500 per year.  We also learned there are 12 months in a year, so $8,500 divided by 12 = $708.  Thus, common sense tells you that your principal will only reduce by every dollar you send in above $708 per month.  This is not rocket science.

Investing Student Loan Debt Money Isn’t So Simple 

Here is the catch.  The major reason I have hesitated to write about it in the past is it falls into the rare category of, “Do as I say, not as I do”.  I’m not a fan of that approach because but it is the only one that leaves me comfortable.  

Using a cost of capital approach, if you carry any debts on your personal financial statements, your job is to lower the cost of those debts to the lowest possible expense you can, while simultaneously making the repayment terms favorable so you don’t face a liquidity strain.

Personally, I am not a big fan of debt with the exception of a public or private corporation optimizing its capitalization structure by issuing long-term, fixed-rate debt securities that have no collateral posting requirements or burdensome covenants that could cause problems at the very moment funds are needed.  

Nobody, or at least nobody honest, takes out debt intending to default on it.  Remember that when you think, “I will someday make enough money to repay this loan.”

With that said, I allow my household to carry student loan debt that could be paid off tomorrow.  Why don’t I just write a check and pay it off to remove it from the balance sheet?  Several years ago, when the world was falling apart and most people couldn’t access bank loans, I took advantage of everything I could and managed to find special programs and deals to lock in the interest rates that went as low as 2.00% per annum with maturities expiring in the next 7 to 20 years.  

In effect, for every $1.00 in capital I am renting from the taxpayers, they are charging me 2¢ per annum.  Inflation is running at 4¢ per annum.  Even if I paid the interest expense out of pocket each year, never amortizing the loan, the “real” debt would drop by 1.92¢ in the first year, declining from there as the value of the dollar depreciates over time.  It isn’t often you have an opportunity to borrow at a rate lower than the inflation rate or the yield on the 30-Year United States Treasury bond.  

My household can afford to carry that liability and I have long lists of places I can put the money to generate good returns.  The payment isn’t significant relative to liquidity, assets, and income.  My job as the CEO of my own life is to manage my resources like a corporation.  I optimize my cost of capital, dropping it as low as possible, then generate the highest risk-adjusted return I can on my assets.  Money is fungible.  I don’t have car debt.  I don’t have credit card debt.  In fact, I have no net debt as my assets greatly exceed my relatively modest liabilities.  Just as importantly, I don’t rely on a single, or even two or three, sources of income to fund my household’s cash needs.  If I had a job that were the sole source of my monthly income, my existing aversion to debt would become a violent allergic reaction.

A not-inconsiderable factor is that I know myself.  I know my track record.  I know my knowledge and my abilities.  I trust my own judgment.  I understand money.  Borrowed money in my hands isn’t nearly as dangerous as it is in the hands of a neophyte who doesn’t know how to put capital to work at attractive risk-adjusted rates of return.  It seems fair to posit that relative to the average guy on the street, the probability of me doing something stupid with the funds in my hands are much lower.

The Bottom Line – Avoid Student Loan Debt

So, no.  I don’t think the average person should take out student loan debt at all.  In fact, I think he or she should pay his or her way through college out of pocket by working an extra job.  There is considerable evidence that a huge portion of the student loan debt incurred by young people is for the room and board portion of the bill, anyway.  Don’t put that on what amounts to an educational credit card.  Be debt free.  It’s such a better way to live.

I don’t know anyone who has ever regretted living debt free.  I don’t know anyone who has sat at his desk and said, “I wish I had another bill I could pay.  My bills are just too low.”

  • calegp

    Write your Congressmen to support HR 2028 which is a very simple law that reverses the law and allows you to bankrupt private student loans!!! More and more co-signers sign this bill so it has viability. 

  • calegp

    Write your Congressmen to support HR 2028 which is a very simple law that reverses the law and allows you to bankrupt private student loans!!! More and more co-signers sign this bill so it has viability. 

    • Joshua Kennon

      Thank you for letting me know about this.

  • http://twitter.com/PFPro1 PF Pro

    Josh, thanks for sharing that bit about borrowing money at lower rates than inflation.  I’ve never thought about that, but it’s a very interesting proposition.  Have you written about this elsewhere?  

    • Joshua Kennon

      Welcome to the site! I am sorry I didn’t see this earlier and am just now responding.

      I haven’t really addressed the topic in-depth anywhere, but I could try to work in a cost-of-debt-capital post in the future.