Rethinking student loans
On Aug. 6, the government extended its forbearance on federal student loans until Jan. 31, 2022. Those who hold outstanding balances will continue to see a suspension of loan payments, a 0% interest rate applied to those loans, and the government will halt collections on defaulted loans. Officials were clear that this is the “final extension” of the student loan payment pause, which began in the spring of 2020, amid COVID19.For those who are still struggling amid the financial fallout from the pandemic, the news was a relief. That said, now is the time to prepare for when the clock starts ticking again. If you have a traditional repayment plan, the forbearance period paused your schedule, but the amount of time when you were not paying will get added to the previous end date.
If you have elected to have an IncomeDriven Repayment Plan (IDR), the COVID suspension will not delay your progress. In fact, the government counts the suspended payments toward your forgiveness. However, “IDR plans recalculate your repayment amount each year to account for changes to your income and family size.”
The flexibility provided to student loan borrowers underscored a notion that economist Beth Akers articulated in her book, “Making College Pay: An Economist Explains How to Make a Smart Bet on Higher Education,” not only does college pay, but contrary to advice on the topic, borrowing to finance higher education may also be a smart form of arbitrage. (Arbitrage describes a situation where investors can buy an asset in one place and then almost simultaneously sell it in another place, so they can capture dislocations in markets, making a tidy profit with a relatively low level of risk.)
When I interviewed Akers for my podcast, she noted that a college education can add nearly $1 million in earnings over the course of a career, which according to research from the Federal Reserve Bank of New York, amounts to a rate of return 15% above what those without a degree earn. Considering that the interest rate on a federal student loan currently stands at 3.734%, Akers contends that those who graduate from their programs with debt are still in better shape than they would have been without the degree. The education arbitrage is the difference between the cost of the student loan and the return on the investment of graduating. With such a wide differential between the two, who wouldn’t want to borrow low and invest to earn a much higher return?
Akers warns that risks exist in the process. There are systemic risks, which are those that you can’t control, like being unlucky and graduating into a recession. But there are also idiosyncratic risks (ones that you can control) that abound in higher education. The arbitrage does not work if you don’t graduate — and unlike other endeavors, there is no partial credit for getting through two years of a four-year program. The return also diminishes if it takes too long to graduate or if students select the wrong college or major.
To minimize risk, families should have frank conversations about what they can afford, and they also need to conduct research. Akers recommends College Navigator and College Scorecard, search tools provided by the government that allow families to consider costs, graduation rates, job placement rates, and earnings.
Through the College Scorecard, young people today have access to data that show. Use the data to do a cost-benefit analysis with your child so you both can understand what costs are worth it, or not. Hopefully, they will remember the session when they are deciding to sign up for basket weaving or accounting.