Understanding Student Loans in the Context of Legal Education (2 of 2) (Michael Simkovic)

So how should our understanding of student loans apply to law students?  Mortgages are routinely repaid over 30-years, even though owner-occupied housing is close to pure consumption (most of the value of housing is consumed as imputed rental income, with appreciation averaging only around 1 percent above inflation). Legal education typically provides a much higher rate of return than real estate, and is probably closer to investment than consumption.  

Rather than focus on initial salaries at graduation alongside student loan balances, it would be more appropriate to emphasize student loan debt service payments, assuming students pay their loans over several decades and with payments that match the expected trajectory of earnings.  This would be an apples-to-apples comparison—initial cash flows compared to initial cash flows.*

It also makes sense to report student loan payments in real terms by subtracting expected inflation (typically around 3 percent) from the nominal interest rate before calculating loan payments.**  (As inflation increases wages and the prices of goods and services, a nominally flat debt payment becomes less valuable in terms of what the money can buy and how much work is necessary to earn enough to make the payment).  Adjusting for inflation won’t take into account the increase in real earnings (above and beyond inflation) that typically comes with additional work experience and secular increases in economy-wide productivity, but at least takes into account increases in earnings that match inflation.

$100,000 in debt repaid in equal installments monthly over 30 years at a 3 percent real interest rate (6 percent nominal) comes to $5,059 per year ($422 per month) in real terms.  In nominal terms (without adjusting for the power of inflation to make debts easier to repay), the payments are $7,200 per year ($600 per month).

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With a graduated extended repayment plan over 25 years, the real initial monthly payments come to $3,420 per year ($285 per month).  In nominal terms (without adjusting for the power of inflation to make debts easier to repay), the initial payment is around $6,000 per year or $500 per month.  

Law graduates typically earn around $60,000 to $75,000 per year to start and have debt service payments of around $3,400 to $7,200 per year.  Recent law graduates have much more cash at their disposal than most bachelor’s degree holders of a similar age even after paying down their loans.

Law students’ incomes can support their debt service payments, as demonstrated by the exceedingly low student loan default rates for recent law graduates.  It is time for the ABA to rethink how law schools disclose debt balances and student loan repayment obligations so that students are not mislead into underinvesting in education. 

Journalists and education experts should also be careful to discuss student loans using apples-to-apples comparison—cash flows to cash flows, and lifetime present values to lifetime present values. 

* If student loan balances or initial cost of education are presented, these should be compared to the expected present value of the boost to earnings from the degree over the course of a lifetime.  Thus, for example, whenever reporting that law school costs around $100,000 on average, it should also be reported that the average value before taxes and tuition is around $1,000,000 and that the median value is around $750,000.

** Part of what graduated loan repayments accomplishes is to make real payments closer to level.  If nominal payments remain flat, as in standard fixed repayment loans, in real terms, payments decline over time and repayment of the loan is front-loaded.