Joshua Kennon

Victims of the Student Loan Industry or Irresponsible Borrowers?

I was reading a site called Student Loan Justice as well as a piece at the Huffington Post where people are talking about their “overwhelming” student loan debt that is – wait for it – $15,000 or $30,000.  Basically, less than the value of a car.  Or a couple both of whom smoke a pack of cigarettes each day for five to ten years. Or 4 to 8 months of pre-tax income for the average American household.

Rational, full-grown legal adults who have the power to vote actually made a decision to borrow money, pay interest for the cost of “renting” that money, and then when it’s time to repay, want the government (read: everyone else, including you and me) to pony up the money because it’s cutting into their standard of living.  One guy on the site, not that long out of college, complains that he has a $1,250 per month payment and can’t live in New York City.  Then get the hell out of one of the most expensive cities in the world! I read a study a few weeks ago that showed New York was the single most difficult metropolitan area for a new college graduate to build wealth.  If you choose to take on a situation where the odds are against you, don’t complain when you don’t win.  Choosing your battles is the first and most important part of coming out ahead in life, just as it is in war or any other undertaking.

Maybe I’m not sympathetic because, as you know, both Aaron and I, as well as most of our friends, were first-generation college students that had to pay our own way through school (complete with a $140,000 price tag for each of us over four years).

I was able to cover at least half of the cost with a vocal performance scholarship in classical music, as was Aaron (which took years of practice and study).  But before I signed a single loan document, you better believe I had read through all of the fine print so I understood the terms, conditions, and pitfalls.  Even so, we were all incredibly frugal.  You all saw the picture of the 1993 Ford Escort Aaron drove with 150,000+ miles long after we had started our first company and he was financially self-sufficient. I mean, he didn’t have heat or air conditioning and drove it during Midwestern winters with ice and -20 degree windchill and summers at more than 100 degrees even though he could have written a check for a new car, while a lot of people we knew bought new cars on credit despite not having any savings or investments.  (I’m going to offer the usual disclaimer here: People who develop health problems get a clean pass because if you are hit with something really bad, it can hurt your finances badly and at that point, staying alive and healthy is more important than you credit score.)

I guess I just don’t understand the mindset that if a full grown man or woman agrees to take something (money) in exchange for something else (the interest rate), why they think they shouldn’t have to live up to the deal to which they agreed.  Now, if the contract were breached, not paying may be a rational form of protest.  In the case of a company insisting on money to which it isn’t entitled, many sane, responsible people wouldn’t cut the check.  But these people acknowledge that they borrowed the money, that they agreed to a contract they didn’t understand, now expect someone to fix it for them.  It seems like they want their cake without the calories (maybe I’m wrong).  They want to have two cars, a decent house, nice clothes, a couple of cell phones, and an X-Box, and they think it’s the bank’s problem they can’t have that because of their student loan payment to which they agreed! Why should anyone else be responsible for managing your life?

In the interest of fairness, I should point out that the student loan debt market is a complete scam because Congress made private student loans virtually non-dischargable in bankruptcy a few years ago, which is utterly and completely indefensible.  Why should one type of loan be protected from market forces?  Sure, costs would rise if defaults could occur, but the pricing mechanism would reflect true economic reality and you wouldn’t get people locked into what become lifetime handcuffs engraved with the words “Sallie Mae” or “Citibank” on them.  However, every student was warned about this before they borrowed the money.

The Interest Expense Isn’t That Big of a Deal if You Structure Your Student Loan Debt Correctly

Even with my student loans locked in on long-term, fixed-rate programs, I used a technique I learned from reading Peter Lynch back in elementary school when I used to hide his books behind my textbook in class.  I forgot what he called it I always referred to it as a “dividend trust account” because that concept made the most sense to me; it basically involves setting us a self-paid trust fund.  Here’s how it works.

One of my student loans is a consolidated $26,019.36 private note, guaranteed by the New Jersey Higher Education Student Assistance Authority, with a 4.25% tax-deductible fixed rate.  The loan will be paid off over the next 211 months, or 17.58 years.  By the end of that period, the total amount paid will be nearly $40,000.

The 4.25% is tax-deductible, meaning that the after tax cost is roughly 2.77% (the student loan tax-deduction phases out after a certain income level but for most people, this won’t apply so we are going to factor it into the math).  Inflation is going to run much higher than the historical 3% it has for the past couple of decades due to the massive government budgetary and trade deficits.  Nevertheless, let’s presume that inflation does remain low at 3%.  With inflation running at 3%, I’m effectively being paid in real “wealth” 1.48% per year to not pay the debt off early.  If I could invest this money at, say, 7% per annum on an after-tax and inflation basis, I would effectively be growing 8.48% richer on the $26,019.36 balance each year in real purchasing power.  The family’s collection of businesses earns a much higher rate of return than this, so the numbers are even more impressive.  I would have to be an idiot to pay off the balance.

So, on my 30th birthday, I am going to establish what I am calling the University Dividend Trust.  I am going to contribute $30,000 in cash to the account and sign a margin borrowing agreement (you’ll see why in a moment).  I will divide the money into three piles, putting $12,500 into a basket of high quality, hand selected blue chip stocks that pay dividend yields of 4.25% or higher, another $12,500 into high quality bonds or other fixed-income-like securities, such as preferred stocks, and the final $5,000 into real estate investment trusts and publicly traded limited partnerships, both of which traditionally feature extremely high cash dividend yields.  My weighted average targeted yield will be 6% per annum on the $30,000 balance, resulting in $1,800 annual cash income for the account plus any changes in the market value of the holdings.

Each month, I will have the fixed-rate consolidated loan auto-debit the payment from this specialty brokerage account.  Otherwise, there will be no transactions.  Each month, if there isn’t enough cash in the account, the difference will simply be covered by an immediately-created small margin loan, held against the account balance.  For instance, if the account had $30,000 in investments in it the first month and no cash, a $189.38 payment would still be covered and the account statement would show $30,000 in assets and $189.38 in margin debt, which results in a bit of interest expense the brokerage account.  As regular dividends and interest are earned in the account, however, they are immediately applied to this debt, wiping out the balance.

Each year, the absolute value of the dividends increase as companies raise prices to keep pace with inflation.  Even if the dividends didn’t increase in real, inflation-adjusted terms, I’d still end up being richer because the debt to is fixed-rate.  That means I can use more absolute dollars to pay a debt that isn’t increasing with inflation. If you don’t understand that concept, let me simplify it.  Let’s imagine that the entire University Dividend Trust brokerage account consisted of shares of Johnson & Johnson yielding 4%.  In the first year, I’d collect $1,200 in cash dividends and roughly $2,272.56 would be taken out of the account, meaning the balance would decrease by $1,072.56 on December 31st if the stock price stayed the same ($2,272.56 withdrawals for student loans – $1,200 cash dividends = $1,072.56 total decrease in account value).  So, I’d have a margin debt of $1,072.56.  Now, the only way I’d get a margin call is if Johnson & Johnson’s share price collapsed by 92.67%!  Spread out across a diversified basket of stocks, this shouldn’t be a concern because if the entire United States stock market loses more than 92% of its value, we have bigger problems than student loan values; people are starving in the streets and there are probably riots.

Anyway, if inflation increases by 3%, it’s likely that Johnson & Johnson will increase prices by 3% and the dividend by 3% as well.  There will also likely be some real growth, say, 2%.  That means that the dividend grows by 5%, even though only 2% represents additional purchasing power because prices have increase for everything from milk to car tires.  That means that next year, though, the account will generate $1,1260 in cash dividends.  The payment on the Sallie Mae debt is still the same.  There is a spread differential that is opening up – the dividend income keeps increasing, even though it’s not all real purchasing power increases – but the debt payment stays the same because it’s fixed rate.  Thus, I’d make money off inflation.

To see this, let’s use an extreme example.  Say that inflation was 100% overnight.  Thus, the price of everything doubled.  The dollar menu at McDonald’s was now the two dollar menu.  A $10 movie ticket cost $20.  The dividend at Johnson & Johnson would go from $1,200 in year one to $2,400 the next year.  Obviously, I’m not richer because it now takes $2,400 to buy the same amount of stuff that $1,200 bought only a year before but – and here’s the kicker - my debt is in fixed-rate terms. That means that the account would earn $2,400 in dividends and still have the same $2,272.56 payments for Sallie Mae.  There would actually be more cash in the account at the end of the year because the dividend income would exceed the debt outflow ($2,400 dividend income – $2,272.56 Sallie Mae payment = $127.44 surplus).  That surplus can be reinvested and start earning dividends and interest.

The result is that over time, through growth in the underlying value of the investments, the dividends distributed to owners, and the nature of fixed-rate debt, the account will “switch” somewhere between 7 and 10 years out in the future so that the outflows are less than the in-flows.  By the end of the 17.58 years, when the $40,000 has been repaid on the $26,019.36 debt, the account will have at least $70,000 and be generating a few thousand dollars a year in cash income.  I can then liquidate the University Dividend Trust, or continue to hold it and take the dividend distributions to buy televisions, or buy clothes each year.

The point is, it is possible to make money off the stupidity of the Federal Government’s fiscal policies.  If the Congress is going to wreck the country’s balance sheet, our first duty is to try and stop it.  If we can’t, we may as well position ourselves to make money off it.  This is one of the reasons I used a fixed-rate mortgage to purchase my primary residence despite my general dislike of debt. With a 5% fixed (5.5% APR) tax-deductible 30-year loan, I am willing to bet that most of the cost will be borne by the nation thanks to the Federal Reserve printing money.  Thus, my money is better spent growing my businesses and investments, rather than reducing debt.  Given that I don’t use debt for consumer purchases, and I avoid it for the most part overall, this doesn’t represent a threat relative to assets, cash flow, and income.

The flip side of the Janus coin is that if I had variable rate debt that was currently low and affordable, I’d be working as quickly as possible to pay it off or convert it to fixed-rate debt because you’re going to get hurt badly when rates skyrocket.  I mean, I’d be putting in double-duty overtime to wipe out the balance.

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