Student loans are a scary ticking time bomb

Last weekend was my law school reunion weekend in Washington, DC. It’s incredible to see how much people have achieved in five years. It is also crazy to see how very little has changed. Some left the legal profession and other stayed, relationships strengthened or fell apart, and overall people look quite good.

 

We shared many fond memories. Looking back, I had the time of my life. If there’s one thing I also remember, it’s how expensive tuition and living in the capital were for someone who had gone to school in Europe. Some of my friends racked several hundred thousands of debt (!) and to this day are still working through their repayment plan.

 

Student loans are America’s next housing crisis. The worst is it is the generation who graduated right after the financial crisis who may be the one to foot the bill again if student loans default picks up.

 

The amount of student loans outstanding is staggering

Bloomberg reported that student loans are the only consumer debt segment that has continually grown since the recession. Over the last 11 years, student loans have surged by almost 157%. Auto loan debt on the other hand “only” increased by 52%.

 

 

It is estimated that there is over $1.5 trillion worth of outstanding student loans. This is the second largest type of household debt after mortgages. Unless wages start to aggressively pick up, I predict that student loans will become the first type of household debt as the new generation is locked out of the housing market due to longer repayment plans and increased house prices. On the other hand, the older generation who has already purchased property will simply pay down mortgages. Only a minority may take a second mortgage to buy further properties.

 

Student loans are the new norm

 

To top worldwide university rankings, universities have raced to improve campuses and hire the best professors to the faculty bench. With no funding from the government, those investments were bankrolled by generous benefactors but also students. Paying over $50,000 a year for a private school education became the norm. That was the price to pay to ensure a successful career.

 

The universities who could not make the required investments were deemed less successful and therefore had a harder time attracting the best students. With less successful graduates and a more humble alumni network, those schools either fell behind the competition or tried to charge even more to students.

 

Unless parents have saved for 18 plus years, students have no choice but to take out massive loans. Sure, a few will succeed in community colleges while others will receive grants. But overall, save for special circumstances, you are looking at a very expensive bill for college and graduate school. And I’m not even counting medical school, which is at another level.

 

It is not like students have slacking either. Students are increasingly spending more time working between studies instead of actually studying. According to Bloomberg, 85% of students have paid jobs while enrolled in a degree.

 

The math really is bad

 

$1.5 trillion means absolutely nothing to me. It is a number that I cannot comprehend. This might be the case for you too. Let’s have a look at some numbers.

 

Calculating the interest rate on federal student loans can be complex and is beyond the scope of this article. A direct unsubsidized loan for a graduate or professional has a 6.6% interest rate based on the Federal Student Aid page. For simplicity, let’s round this down to 6%.

 

The cost of attendance of Georgetown Law for the current academic year is $62,244 a year for a full-time JD student. That’s $186,732 because the degree lasts three years.

 

Let’s assume that your parents were generous. They paid for college and you don’t have any outstanding student loans. Let’s also assume that you are hard-working and that you are able to pay for food, rent, and extra-curricular activities by yourself or with a bit of help from your parents.

 

The goal is to pay student loans within 5 years, i.e. before your first reunion. After all, you might get married and you will want to save for a house in not so long.

 

I know that’s a lot of assumptions.

 

Here is the breakdown of your monthly repayment schedule.

 

And here are the results:

Monthly payments amount to $3,610.05. That is a staggering amount. Just to put this into perspective, I strongly believe that only law graduates in Biglaw (i.e. working for big law firms paying top dollars in exchange for your life and sanity) would be able to service such a high amount. A first-year associate working in a top NY law firm will make $190,000. That’s a great amount when you just graduated from law school. But half of that will go towards federal and especially state taxes. Then you need to rent a place in one of the most expensive cities in the world. And of course, everybody needs to go out from time to time. After servicing the monthly payment of $3,610.05, there won’t be much left to save.

I know that some people will argue that 5 years is too short. That assumption is not realistic and too aggressive some might say. Think again. You should not be paying servicing debt with such a high-interest rate. You may be able to refinance but that won’t drastically change things. Banks will be reluctant to lend you significant amounts for a mortgage if you still have $100,000 to pay to the government for debt that cannot be discharged in bankruptcy.

 

Of the amounts repaid, almost 14% will account for interest. Imagine what you could do with $30,000!

As with most loans, including mortgages, students will mostly repay interest at first and only the principal then.

 

The student loans crisis is likely to get worse

Student loans have the highest 90-day delinquency rate of all types of household debt. This means that people with student loans are more likely to default on the debt compared to others with credit card debt or mortgages. According to Bloomberg Global Data, more than 1 in 10 borrowers is at least 90 days delinquent compared to mortgages and car loans that respectively have a delinquency rate of 1.1% and 4%. Mortgage and car loans delinquency peaked during the housing crisis and started to decrease in 2010. On the other hand, student loan delinquency rates have remained very close to the all-time highs reached in 2012.

As the Fed continues to raise the base rate, the options to refinance student loans at a cheaper rate are dwindling rapidly. The U.S. Government is also unlikely to reduce rates anytime sooner given how much money this brings to the coffers. Universities are still locked in a global race against one another and are therefore unlikely to cut tuition fees and sacrifice a key source of funding.

Student loans are getting more expensive but this does not mean that students equally face increased risks of defaulting. Some student classes are more vulnerable than others:

• For-profit colleges: in the US, some schools simply exist to make money. Often, the education is below par but this does not prevent those institutions from charging exorbitant tuition fees. Students graduate from a school that has at best an average reputation and cannot find jobs with salaries sufficiently high enough to service the debt.
• People of color: people of color tend to be more at disadvantage in the United States because of a poorer background and years of prejudice against them. Colleges have put affirmative action admission procedures to ensure that everybody has a fair chance of getting admitted. However, this does not always translate into scholarships and financial aid.
• Drop-outs: people who started paying for a very expensive degree and don’t even graduate are also likely to default. If you don’t graduate, employers cannot hire as you don’t have the requisite qualifications. Yet, you still have to repay those student loans. The exceptions are drop-outs who launch very successful companies such as Mark Zuckerberg or Bill Gates.
• Graduates with limited job opportunities: you may be the brightest in your field but there must be some jobs available. If you studied speech writing and literature to become a speechwriter at the White House, then you are going to have a rough time financially because only have 5 to 10 people will have that job every four years. On the other hand, if you studied computer science, you could probably get a job prior to graduation. This world is evolving quickly and some job opportunities just disappear as they are no longer relevant.

 

Students are smart and know that defaulting on such a large amount that early on in life will have long-standing implications. Their credit score will drop and they will not be to borrow and use leverage to buy a property. In the United States, it is almost impossible to discharge student loans so they will always get chased by some debt collectors. It is incredibly hard to recover financially. Therefore, I don’t think that people who default on their student loans do it just for the fun of it. They have encountered tremendous hardship and decided to give up fully knowing the dire consequences of doing so.

As Jerome Powell, the chair of the Federal Reserve said:

“You do stand to see longer-term negative effects on people who can’t pay off their student loans. It hurts their credit rating; it impacts the entire half of their economic life”

 

 

The only way to limit any downside is to take calculated risks. Don’t take on massive loans if you don’t get into a decent school. Be mindful that some jobs are harder to get or pay less. Be realistic about your prospects. Yes, everybody is getting an education and it is harder to have a successful career without one. Yet, remember that an education is supposed to be an asset, not a liability. And people in the UK, including Cabinet members, should be mindful that UK students are following their US counterparts a lot quicker than everybody thinks by taking on more debt.