Monday, June 15, 2015
Understanding Student Loans (1 of 2) (Michael Simkovic)
A shorthand approach sometimes used to compare the cost and benefits of higher education—comparing student loan balances at graduation to first year earnings—can be seriously misleading. The implication of this approach is that student loans have to be repaid in full shortly after graduation, and that graduates’ low initial earnings will persist for the rest of their lives.
This is an apples to oranges comparison. An investment in education pays dividends throughout one’s life. First-year earnings are one small, unrepresentative, slice of lifetime earnings. Comparing a lifetime investment to one year of expected returns on it feeds ignorance about how student loans and lifetime earnings actually work. It thus risks misleading prospective students into making financially disastrous decisions to underinvest in education.
Student loans are meant to solve a specific problem—the costs of education come as a series of large upfront payments for tuition and living expenses, while the benefits accrue later in life in the form of higher earnings. Except for the minority of students who are fortunate enough to have rich and generous parents who cover their tuition, students generally have two options—save or borrow.
Saving is inefficient because it requires students to work for many years with a lower level of education and for much lower wages, and to complete their degrees much later in life. Completing a given level of education earlier helps maximize the number of years of expected higher earnings with a higher level of education. Borrowing to invest in education is therefore more efficient than saving to invest in education. Some of the benefits of financing accrue to the student borrower in the form of higher lifetime earnings compared to saving, and some of the benefits accrue to the lender in the form of interest and fees. Another approach to financing higher education—more popular in Europe, Australia, and Canada than the United States—features higher public spending and higher tax burdens, sometimes with a tax-like percent-of-earnings fee explicitly tied to university education. The social democratic approach, like the U.S. approach, involves providing something of value up front in return for a fraction of graduates’ incomes later.
Student loans enable students to pay for their own education by converting the cash flows associated with investment in education from large upfront payments into a series of much smaller payments spread out over time. Ideally, these payments should closely match the timing of the benefits of education—that is, the timing of the boost to earnings from education.
Because the benefits of education accrue over the course of a career—perhaps 40 years or more—and earnings typically do not peak until middle age, the costs of education should ideally also be spread over a similar time frame.
The prospect of high payments needed to pay back loans very quickly ex-ante could cause prospective students to underinvest in education. As life expectancy and career length increase, so should initial investment in education.
If this goal of matching the timing of cash flows is accomplished, then at every point in time, with more education, students will have more cash at their disposal. The boost to earnings from education will more than cover student loan debt service payments, and the initial borrowing will enable students to maintain a decent lifestyle while pursuing studies instead of working full time. (For a discussion of the advantages of leveraged investments early in life, see Ayers & Naelbuff).
That is one important reason why federal student loans can be repaid over 25 to 30* years (so-called “extended” repayment). Plans are available under which monthly payments start low and increase over time to match the typical trajectory of lifetime earnings (“graduated” or “graduated extended” repayment), or in which payments dynamically adjust up and down with actual borrower earnings (if earnings fall below a certain level) to better match cash flows (“income-contingent” or “income-based” repayment).
Because these extended and income adjusted plans are better tailored to the purpose of student loans—matching positive and negative cash flows—one of these plans should be the default option for student borrowers instead of the now “standard” 10-year repayment period. 10-years to pay for an education that provides benefits over 40 years makes little sense. For law graduates, real earnings typically continue to grow for 30 years after graduation.
* Consolidated loans can be repaid over 30 years, but some consolidated loans may not be eligible for income based repayment plans.
Paying loans back slower typically will not affect the economic value of education, notwithstanding the fact that nominal interest payments will increase. Paying loans back faster or slower typically will not affect the economic value of education as long as two conditions are met:
- Interest rates remain unchanged regardless of whether a loan is repaid over 10 or 30 years (this is the case for federal student loans, but not for mortgages or most other debt instruments most of the time)
- The interest rate on student loans is appropriate, in that it matches up with default and loss risk levels for lenders, the opportunity cost of capital, and time preferences.
If condition 2 holds, then the interest rate will equal the discount rate which is used to convert cash flows occurring at different points in time into the same currency so that they can be compared. If the discount rate is 6 percent, then there is no valuation difference between paying $1,000 today or paying $1,060 one year from now, just as there is no difference between paying one U.S. Dollar or the equivalent in Euro cents. If students choose to refinance or pay their loans back faster than they are legally required to repay them, this suggests that the interest rate on student loans is too high.