Since I don't have any student loans this doesn't pertain to me, but say a student qualifies for a $5,000 subsidized Federal loan at 4.5% interest. If they only use $3,000 of the $5,000 (per year), what should they do with the rest? Pay it back immediately? Invest it?
Student loans (hypothetical)
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OurLifeInc.
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Use it as a downpayment on a brand new car.
I kid, I kid.
Anyways, my personal opinion would be to pay it back immediately. By paying it back you would be guaranteed a 4.5% return. You could invest it in a steady dividend payer (EXC, maybe?) that pays over 4.5%, however then you are subject to the market. What happens if the worst case scenario plays out? Being as I loathe debt (and am made at myself over my mortgage, but that's another story) and tend to be conservative, I would pay it back right away.
I kid, I kid.
Anyways, my personal opinion would be to pay it back immediately. By paying it back you would be guaranteed a 4.5% return. You could invest it in a steady dividend payer (EXC, maybe?) that pays over 4.5%, however then you are subject to the market. What happens if the worst case scenario plays out? Being as I loathe debt (and am made at myself over my mortgage, but that's another story) and tend to be conservative, I would pay it back right away.
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jacob
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Pay it back.
If you had asked in March 2009, I might have answered differently, but now is not a good time to buy on margin. If 30 year treasure bonds were currently paying 6%, I'd certainly answer differently---the student loan carry-trade is a time-honored tradition amongst those in the know
[which unfortunately wasn't me when I was that age].
If you had asked in March 2009, I might have answered differently, but now is not a good time to buy on margin. If 30 year treasure bonds were currently paying 6%, I'd certainly answer differently---the student loan carry-trade is a time-honored tradition amongst those in the know
[which unfortunately wasn't me when I was that age].-
futuredoctor
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The reason I was wondering is because I myself flat-out refused the loan I described when it was offered to me a few months ago. I wanted to avoid debt at all costs so I didn't even consider it. My parents are carrying the ~$3,000 balance per year (although I'd like to pay them back when I can). I recently realized that maybe I could have used the loan money to my advantage, but I don't feel I'm knowledgeable enough so I'm uncomfortable with the idea.
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AlexOliver
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George the original one
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Personally, I would invest it, but that's because I have the confidence and experience to do so. I'd purchase a municipal bond fund yielding 6.5-7+%, preferably at a discount to NAV, and be ready to sell when interest rates are raised and/or the NAV begins dropping and/or the discount/premium to NAV goes wonky.
I took every dollar of Stafford loans offered to me... I consolidated at something insanely low, like 1.8%.
I still have 18k in student loan debt at 2% interest... After tax deduction this is probably more like 1.5% interest.
I'm not paying the loan off until checking account yields go under 2%... I've made made thousands in arbitrage.
Besides, you never know, there might be a bailout of stupid loans... Although, I certainly hope not.
I still have 18k in student loan debt at 2% interest... After tax deduction this is probably more like 1.5% interest.
I'm not paying the loan off until checking account yields go under 2%... I've made made thousands in arbitrage.
Besides, you never know, there might be a bailout of stupid loans... Although, I certainly hope not.
A common response to this scenario (see above) is to suggest that if the rate of return that can be gained through investment is sufficiently greater than the rate of interest on your student loan (which for a subsidized loan will be 0% for a period of time), then you should borrow the money and invest it.
I would like to suggest that there are other factors to consider. First, realize that most, if not all, student loans have an origination fee. These fees tend to range between 1% and 4%. So, when I was in school, if I borrowed $1000, I got a check for $970, because the origination fee was automatically deducted. So, if the origination fee is 3%, you’ll have to earn about 3.1% (after taxes), just to break even at the end of 1 year.
Second, realistically speaking, with the (less than) $2000 you have to potentially invest, you’ll probably earn less than $30 in your first YEAR, unless you take some risk. If you perpetuated this scheme every year for 4 years, you might make a few hundred bucks over 4 years. Keep in mind these numbers are before taxes, though the tax implications will vary significantly depending on your other income (if any), and your investment choice.
Third, when I was in school, we were told that it was illegal to use student loan money to buy a car, or for the purposes of investment (I don’t know if this is true). I know people who did both of these things, and I don’t know anyone who was “caught”. You might however, find it a bit uncomfortable to report your investment income if you did happen to have good success with your investments. Imagine, for instance, you had the good fortune of doubling your $2k in one year. You’ll have to report that income on your taxes, and you’ll probably have to report that income when you apply for financial aid next year. If you were audited, you might be in an undesirable situation.
Also, there are aggregate student debt limits, above which you will not be loaned any more government backed money. If you expect to borrow for grad school, you may not want to have a bunch of active loans that you don’t actually need. Perhaps you can retire the debt at just the right time to retain all of your eligibility, but it seems like a lot of effort to me, to make a few hundred bucks.
JohnnyH notes that he’s made “thousands” in arbitrage, but realize that he has a consolidation loan with a rate of 2%. My understanding is that the loan program has changed such that low rates like that are no longer possible. Furthermore, in order to have made thousands, I can only deduce that some of the following must be true: large loan amounts (say $80k and up), he’s been holding the loan longer than you will (greater than 4 years), or he’s taken risk beyond a checking account, CD, or money market acct. What checking acct yields greater than 2% btw?
As an example, imagine that you were to graduate with $8000 in student loan debt, and $8000 in the bank. By magical luck, you get JohnnyH’s 2% rate. If you term the $8k over 30 years, your loan payments will come to about $355 per year. In order to make $355 per year on the $8k you have in the bank, you’ll need to earn a return of 4.44%. There are tax implications, so if we put you into the 15% tax bracket and assume that your investment income is taxed as income (not capital gains), you’d have to earn a return of 4.87% in order to cover the payments. And, you’ll actually have to do better than that in the later years of the loan because you’ll be paying less in interest.
Later in life people will make the same argument to you about prepaying a mortgage: they’ll argue that if the mortgage rate is low you shouldn’t pay it off, instead you should invest the money. They may be right if you’re going to work for another 20-30 years. If you want to stop working at a young age though, it seems to me that you either have to have low expenses or a large amount of money.
In summary, I think it’s a reasonable strategy to not borrow the money, or to borrow the money and set the surplus aside as part of a plan to make sure you can fund your education. It’s okay to put the surplus in a CD or interest bearing account in order to maximize your situation, but it seems pretty unlikely that you’re actually going to make a good deal of useful money with the extra $2k unless you’re willing to take on a good deal of risk, so don’t get caught up in the idea that you need to be “investing” this money.
I would like to suggest that there are other factors to consider. First, realize that most, if not all, student loans have an origination fee. These fees tend to range between 1% and 4%. So, when I was in school, if I borrowed $1000, I got a check for $970, because the origination fee was automatically deducted. So, if the origination fee is 3%, you’ll have to earn about 3.1% (after taxes), just to break even at the end of 1 year.
Second, realistically speaking, with the (less than) $2000 you have to potentially invest, you’ll probably earn less than $30 in your first YEAR, unless you take some risk. If you perpetuated this scheme every year for 4 years, you might make a few hundred bucks over 4 years. Keep in mind these numbers are before taxes, though the tax implications will vary significantly depending on your other income (if any), and your investment choice.
Third, when I was in school, we were told that it was illegal to use student loan money to buy a car, or for the purposes of investment (I don’t know if this is true). I know people who did both of these things, and I don’t know anyone who was “caught”. You might however, find it a bit uncomfortable to report your investment income if you did happen to have good success with your investments. Imagine, for instance, you had the good fortune of doubling your $2k in one year. You’ll have to report that income on your taxes, and you’ll probably have to report that income when you apply for financial aid next year. If you were audited, you might be in an undesirable situation.
Also, there are aggregate student debt limits, above which you will not be loaned any more government backed money. If you expect to borrow for grad school, you may not want to have a bunch of active loans that you don’t actually need. Perhaps you can retire the debt at just the right time to retain all of your eligibility, but it seems like a lot of effort to me, to make a few hundred bucks.
JohnnyH notes that he’s made “thousands” in arbitrage, but realize that he has a consolidation loan with a rate of 2%. My understanding is that the loan program has changed such that low rates like that are no longer possible. Furthermore, in order to have made thousands, I can only deduce that some of the following must be true: large loan amounts (say $80k and up), he’s been holding the loan longer than you will (greater than 4 years), or he’s taken risk beyond a checking account, CD, or money market acct. What checking acct yields greater than 2% btw?
As an example, imagine that you were to graduate with $8000 in student loan debt, and $8000 in the bank. By magical luck, you get JohnnyH’s 2% rate. If you term the $8k over 30 years, your loan payments will come to about $355 per year. In order to make $355 per year on the $8k you have in the bank, you’ll need to earn a return of 4.44%. There are tax implications, so if we put you into the 15% tax bracket and assume that your investment income is taxed as income (not capital gains), you’d have to earn a return of 4.87% in order to cover the payments. And, you’ll actually have to do better than that in the later years of the loan because you’ll be paying less in interest.
Later in life people will make the same argument to you about prepaying a mortgage: they’ll argue that if the mortgage rate is low you shouldn’t pay it off, instead you should invest the money. They may be right if you’re going to work for another 20-30 years. If you want to stop working at a young age though, it seems to me that you either have to have low expenses or a large amount of money.
In summary, I think it’s a reasonable strategy to not borrow the money, or to borrow the money and set the surplus aside as part of a plan to make sure you can fund your education. It’s okay to put the surplus in a CD or interest bearing account in order to maximize your situation, but it seems pretty unlikely that you’re actually going to make a good deal of useful money with the extra $2k unless you’re willing to take on a good deal of risk, so don’t get caught up in the idea that you need to be “investing” this money.
All true, Mo. I got my first loan in the late 90s, so I've had them forever. Also, these are deferred interest, so I had 4 years of utilizing the money before interest started to accrue.
Things seem to have changed significantly since I graduated. My GF who is graduating now hasn't seen anything near the low rates I consolidated at... I find this puzzling because rates are ridiculously low right now.
As far as the only using money for student expenses, I find that fairly ridiculous... I worked and earned 5k and I took 5k loans. The money ended up in a checking account, so who's to say which was invested and which was used towards school.
I still have some of the loans in CD ladders, but have been moving out of CDs for years since internet accounts are paying more. Rewards checking accounts are paying over 2%, some as high as 5%. There are hoops to jump through, but easily done. I think SmartyPig is paying 2.25% without any caveats.
Run the numbers, it's possible this is no longer profitable, but I would not be at all surprised if it still was.
Things seem to have changed significantly since I graduated. My GF who is graduating now hasn't seen anything near the low rates I consolidated at... I find this puzzling because rates are ridiculously low right now.
As far as the only using money for student expenses, I find that fairly ridiculous... I worked and earned 5k and I took 5k loans. The money ended up in a checking account, so who's to say which was invested and which was used towards school.
I still have some of the loans in CD ladders, but have been moving out of CDs for years since internet accounts are paying more. Rewards checking accounts are paying over 2%, some as high as 5%. There are hoops to jump through, but easily done. I think SmartyPig is paying 2.25% without any caveats.
Run the numbers, it's possible this is no longer profitable, but I would not be at all surprised if it still was.
The way that interest rates for consolidation student loans are determined was changed a few years back. I doubt many people borrowing today will be able to make money during the repayment period.
You're right that the money is hard to track for someone who has earnings, but it becomes a lot easier if you have no earnings. Despite this, I know several people who used their loan money to invest, and none were "caught" in any way.
There are so many variables, it's really hard to know if you're making money or not without having all of the specifics. In my arguments above, I didn't account for inflation, state taxes, the possibility that you might hold your money in an IRA, 401k, etc, or that you could invest in something subject to capital gains tax, or perhaps not even subject to tax. In general, you're more likely to be making money early in the repayment period, and if you reduce the tax burden on your investment income. Naturally, the bigger the difference b/w investment return and loan interest, the more likely you are to come out on top.
You're right that the money is hard to track for someone who has earnings, but it becomes a lot easier if you have no earnings. Despite this, I know several people who used their loan money to invest, and none were "caught" in any way.
There are so many variables, it's really hard to know if you're making money or not without having all of the specifics. In my arguments above, I didn't account for inflation, state taxes, the possibility that you might hold your money in an IRA, 401k, etc, or that you could invest in something subject to capital gains tax, or perhaps not even subject to tax. In general, you're more likely to be making money early in the repayment period, and if you reduce the tax burden on your investment income. Naturally, the bigger the difference b/w investment return and loan interest, the more likely you are to come out on top.