Student Loans…Not All Debt Is Created Equal

By Joseph Reinke, CFA, CEO of FitBUX

Young adults are being advised that higher education is a must for their futures. Statistics showing the benefits of higher education proves this advice is indisputable. However, what young adults are not being told is the following: just because the government is willing to write someone a blank check to attend college (specifically advanced degrees) does not mean one should take the money. Not heeding this advice can set you back financially for a long time, if not for the remainder of your life. In short, not all debt is created equal.

This article...

  1. Explains what asset you are investing in by attending school and the financial theory behind it;
  2. Uses the example of financing a home versus financing your education to illustrate why all debt is not created equal;
  3. Examines the amount of debt you should target to finance your education and steps you can take in school to lower your debt load; and
  4. Discusses why return on investment (ROI) calculators don't provide you with an appropriate decision on the amount of financing you should take to finance your education.

Financial Theory...Building Your Greatest Asset - Your Human Capital

When we think of assets we think of tangible and financial assets such as a home, stocks, bonds, autos, etc... However, there is another type of asset that an individual possesses. In finance, we call this intangible asset your human capital asset. At a high level, your future income and the risk to that income has a value today. Financial theory says that a young person's number one asset is that person's human capital asset because that person has not had time yet to build up his financial assets. Over time, the person will translate that human capital into financial capital through the receipt of pay checks, saving a portion of those earnings, and investing those savings. In essence, over time our human capital asset decreases and should be used to increase our financial assets.

Student Loan not all debt is equalOne of the major inputs that determines the value of our human capital is the level of education we obtain. All else equal, the higher the level of education we complete, the more likely our future income will increase, which increases the value of our human capital today. Remember though, this assumes all else is equal. This assumption is important, and we will touch on why later in the article but first we will explain why student loan debt is not equal to other forms of debt.

Student Loans Versus Home Loans

I have had students ask me "Why are you saying I can't afford $200,000 in students loans but the bank says I can use $200,000 in loans to buy a house?" This is primarily the case because you have a limited amount of time to convert human capital to financial assets. For example, if you are 30 years old when you graduate and plan on retiring at 60, then you only have 30 years to convert your human capital to financial assets for retirement. Using your human capital to pay student loans is much different than using it to pay for a home loan.

For example, let's assume you recently graduated from an advanced degree, receive a post-graduation salary of $80,000, and have a student loan balance of $200,000. The loan is expected to be paid off over 30 years, which means that as you recognize your human capital asset in the form of wages, you will use it to pay off your student loans. After 30 years you are debt-free, but you also have not accumulated much financial assets.

Now compare that to a real estate loan. If you graduated with no debt and instead took out a real estate loan of $200,000 with a 30 year term, over time when you recognize your human capital asset in the form of wages you are also paying down the home loan. At the end of 30 years, you would have no more debt, but you would also have a financial asset...your house.

The moral of this story is that just because an entity is willing to give you a blank check to go to school, that does not mean that it is in the form of good debt. There is a tipping point whereby the increase in human capital that you receive from furthering your education is negated by how much you borrow. In essence, do not borrow blindly.

The Student Debt Ratio You Need To Know and What You Can Do While In School

To be in a decent position when you graduate, we use a general guideline of a 1:1 ratio in the finance industry (this varies with each individual). This means that your total loans should be less than or equal to your expected annual earnings upon graduation (i.e., if you expect to make $80,000 per year, your student loans should be less than or equal to $80,000 once you graduate). Above that ratio and you run the risk of not having the ability to turn your human capital asset into enough financial assets in the future to make your education “worth it,” strictly from a financial perspective.

Many of you are probably thinking, "There is no way I can complete my studies and meet that ratio." As harsh as it sounds, you should do everything you can. This could mean working part-time or full-time during your studies. It also means trying to get grants and scholarships. You may have to sacrifice "having a life" while in school but the sacrifice you make will be well worth it in the long run.

Deciding how much in student loans you should use for education is a hard question to answer. To make the decision making process even more challenging, many of the “helpful” tools available today may not be as valuable as they seem…

What Traditional School ROI Calculators Miss

Often times individuals contemplating an advanced degree will use return on investment (ROI) calculators to determine if getting their advanced degree is "worth it." The problem is that these simple calculators only look at the increase in income one would expect after graduating and compare it to the cost of financing one's education. By capturing the increase in one's expected income, these calculators are capturing the increase in one's human capital value. However, these calculators do not capture the increase in risk with that expected earnings increase. They simply assume that the additional cash flows from obtaining higher education have no risk. Thus, they paint an incomplete (and often inaccurate) picture of one's overall future situation.

For instance, many who pursue an advanced degree may be doing so to change industries. However, that new industry may have a higher level of risk. The industry may be more susceptible to contractions during economic downturns, which increases the risk to one's future cash flows. This risk is not captured by using simple averages of graduates. You may also decide to work part-time to stay at home to care for children. There are many different reasons why there are risks to the incremental earnings. In addition, these calculators do not capture the risk of adding a fixed cost (your loan payments) to your financial outlook and also don't take into account other factors about your personal financial situation. These factors may include things like other debts you might have, such as a mortgage, an auto loan, or undergraduate student loans. They also do not take into account factors such as how stable your spouse's job may be, how many children you have, or other expenses you might incur.

In addition, there are many different factors that reduce or increase the risk to your "employability." For example, hiring managers of MBA candidates have said they look for candidates who had 3 to 6 years of work experience before entering their MBA program rather than candidates that went straight to business school after college. This means the expected increase in earnings post MBA may be more difficult for some graduates to obtain. Most of these factors are simply ignored by traditional ROI calculators.

OK, So Now What? Help Us, Help You! (Really)

All of the above are reasons why FitBUX is building a holistic financial engine that encompasses all of the factors discussed above as well as other items to help individuals with their decision making process when faced with a question like: "If I pursue an advanced degree, what effect does the amount of student loans I expect to take out have on my personal situation, taking my past, present, and future into account." If you would like to get a holistic picture of your personal situation and how FitBUX can help you, sign-up for free by clicking the link below. Of course, if you know somebody this article may help , please forward them this article.

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