The Psychology Behind Student Debt

            Student debt is a growing concern among Americans as we have now pasted a trillion dollars nation-wide. Student debt isn’t always needed and higher education is not always worth the cost but I will cover higher education issues in another post. The issue at hand is how to make smart decisions on how to repay the loans. The one decision that I would like to cover is investing.

            I have heard from many people including financial planners who recommend making investments as a way to save for one’s retirement. I agree that retirement is an important goal to look towards but there is a psychological pitfall by investing while having student debt. Many people feel that investing now will make you millions of dollars and that is far more than your student loans. This is wrong.

            Students should be looking at the returns not the total “expected" amount. A Federal Stafford loan has an interest rate of 6.8% and a Federal Graduate Plus loan has a rate of 7.9%. There are also Federal Perkin loans which have a 5% interest rate and private loans which can have lower rates as long as you have good credit. Private loans offer little or no repayment options. Most students will have a rate between 6.8% - 7.9%. Now it is crucial to understand that debt (loans) are the same as an inverse investment since you will have cash outflows instead of expected cash inflows. For comparison, a 10 year bond (the same maturity as a Federal student loan) today is yielding 2.14% (risk-free rate). The average stock return is about 8% over the long-run.

            Now you can clearly see that borrowing money at any of the rates above and receiving returns at the risk-free rate yields a negative return (2.14 – 6.8 = -4.66%). Now there is the option of investing in stocks with the assumption that you will get 8%. The 8% however is risky and the additional 5.86% is compensation for taking the risk. The 8% return is an assumption that an individual holds the market portfolio over a very long period. Holding a well-diversified market portfolio is also costly in many ways which reduces the 8% return.

            A student is best off reducing their monthly expenses by paying off the debt as soon as possible. If a student has excess money it should go towards paying down the highest interest rate loan or by paying down the smallest loan and using the snow ball approach that Dave Ramsey recommends. By investing in risk-free assets you are reducing your wealth and by investing in risky assets you are exposing yourself to financial hardships and uncertain returns.

            The psychological pitfall is to assume that retirement is your end goal and offers a higher return than the cost of your college debt. The end goal for everyone should be to maximize wealth which needs to be done with the consideration of risk and return. Paying off your student loans first and then making investments once the debt is gone is the best way to maximize wealth with low risk. If you end up landing a job after college and the company matches up to a certain amount for a retirement account you should in this case make an investment since the risk/return is far better than the cost of the debt. I would however not invest any more than what they will match. The take home lesson here is to consider your debt interest rates against your investment interest rates and make sure that you maximize your returns as best as possible.