In this opinion piece, Wharton finance professor Michael R. Roberts argues that a basic understanding of finance will help students and their parents avoid making dire decisions, such as taking out excessive student loans. .
The student loan crisis has been in the news for some time. A recent the Wall Street newspaper The article describes the financial disaster that plagues graduate students saddled with debts they will never be able to repay and the taxpayers who will end up paying for these unpaid loans. However, this is just one example of the many financial decisions that change the lives of young people (and old people) and the implications of those decisions that extend beyond policymakers. The fact that many people make financial decisions with little understanding of their implications explains why finance should be compulsory for every high school student.
Now, as a finance professor, I realize that this statement sounds awfully selfish, but it shouldn’t be controversial, and I speak from experience. I took out student loans to finance my graduate studies with no idea of the future financial burden. I was lucky. My loans were small and I found a job that allowed me to pay off my loans quickly. What I should have done before taking out the loans was spend an hour or two figuring out my future loan payments and whether I would be able to pay them with my job prospects after getting my diploma.
Let’s perform this exercise to illustrate how easy and informative it can be to use Columbia’s graduate film program highlighted in the the Wall Street newspaper article as an example.
How much do we need to borrow to complete the program? It depends on the cost of the program and living expenses minus the money we contribute. While estimating what we’ll owe when we graduate seems straightforward, there are a few wrinkles. First, loan fees are often deducted from what we borrow. In other words, we need to borrow more than we need to cover these costs. Second, interest accrues on the loans as soon as you receive the money, a feature common to most loans. The result is that students are often surprised (shocked) that their outstanding balance after graduation is significantly more than what they thought the cost of their education would be.
“The fact that many people make financial decisions with little understanding of their implications is why finance should be mandatory for every high school student. “
The Columbia program currently costs approximately $ 70,000 plus $ 30,000 in living expenses. Suppose these costs don’t change next year and we don’t have the money to cover these costs. Suppose also that there are no borrowing fees and we need to borrow all of our expenses for each year at the start of the year. In other words, we borrow $ 100,000 at the start of the program and $ 100,000 a year later.
Current federal loan rates are around 6%, according to the Federal Student Aid website. When we graduate in two years, we will owe the federal government about $ 100,000 x 1.062 + $ 100,000 x 1.06 = $ 218,360. Accrued interest translates into over $ 18,000 in extra money we owe upon graduation, assuming we didn’t make payments while in school. Consider longer programs, like law and medicine, and you can understand the shock of the sticker at graduation.
Now let’s see what our monthly payments will be when we graduate. There are many payment plans and variations on the interest mix, but at the end of the day the amount of our loan repayments will primarily depend on how quickly we can repay the loan.
Figure 1: Monthly loan payments for different repayment horizons
Figure 1 shows how the monthly payments vary with the loan repayment time; longer payment plans, lower payments.
Armed with this knowledge, we can estimate how much we need to earn to pay off our loan and pay for living expenses after graduation. Assuming a 10-year payment plan, we’re looking at just under $ 30,000 per year in loan repayments. If our annual living expenses are similar, we will need around $ 60,000 per year after tax to cover our loan repayments and living expenses. At an effective tax rate of 20%, these needs require an annual gross salary of $ 75,000. Figure 2 shows the gross income requirements when we vary our loan repayment time and therefore the monthly payment amount.
Figure 2: Gross income required to pay loan repayments and living expenses
Now it’s time to check the reality: will our degree lead to a job with the gross income needed to pay off the loan and provide a living income? While we can’t know for sure, we can understand the risk we are taking. Most schools will, or should, provide information on placement and average salaries for their various programs. Thus, we can determine the likelihood that we will get a job that covers our future expenses.
Of course, there is always uncertainty even with thoughtful financial analysis. Maybe we will graduate during a recession and have difficulty finding a job or face lower wages. Perhaps personal circumstances will change in a way affecting our employment prospects. These uncertainties do not detract from the importance of in-depth financial reflection before a big decision, they amplify it!
“While we can’t eliminate uncertainty, we can prepare for it. “
The above analysis shows that we can accept a lower paying job by simply stretching the payments out over a longer time frame. It also shows us the minimum amount we need to earn to cover our loan payments and living expenses. By changing some numbers and assumptions, we can ask a myriad of “what if” questions. What if we took a teaching job while we were in school to cut some of the costs? What if we used some of our savings to reduce our loan amount? More generally, finance provides a simple framework in which we can make important decisions from a position of clarity and understanding. So while we can’t eliminate uncertainty, we can prepare for it.
The emphasis here on student loans, while illustrative, is not unique. Auto loans and rentals, home loans, credit cards, savings and investment, retirement planning, etc. are all examples where a little financial thinking in the beginning can pay huge dividends. – pun intended – later. It is important to note that the analysis performed here, while approximate, is not only informative but easy to perform. The calculations require nothing more than arithmetic and could be done by most kids in middle school.
Imagine a generation of teens and young adults ready to face financial realities.