The Obama administration recently announced new initiatives in an effort to fix the many problems of the public-private student loan system in America. These include allowing new borrowers to limit repayments to 10 percent of income above the poverty level, providing for loan forgiveness after 20 years of responsible repayment, and giving preferential treatment to those in public service.
To understand the importance of these initiatives, it helps to consider student loans as an investment.
In the McCombs School, all students learn about “financial leverage,” which is a tool used by companies to increase growth. This concept holds that incurring debt can be beneficial when it creates financial returns that exceed the costs imposed by the debt obligation. Simply put, if I can borrow $1,000 at a reasonable rate of interest and use it to make $2,000 in a reasonable period of time, I come out ahead.
Despite all of the angst about student loan debt, a student loan can be great financial leverage. A recent article by the Economic Policy Institute notes that entry-level college graduates make $20 per hour, on average, while high school graduates make only $10 per hour. Similarly, a recent New York Times article noted that the average hourly pay for all college graduates is $32.60, versus $16.50 for everyone else.
If a college graduate works 40 hours per week and pays income taxes at a rate of 25 percent, that $10 per hour entry-level difference is a return of well over $1,000 per month. With student loan rates at 4.66 percent (effective July 1), that difference alone will pay off $100,000 in student loan debt in 10 years. But a new report by the White House Domestic Policy Council and Council of Economic Advisers notes that the average student debt at graduation is $29,400, leaving a substantial surplus after covering the loan payment.
Of course, the cost of a college education is not just the cost of student loans, just as the value of a college education is not just in its financial returns. But, if taking out those loans is the difference between attending and not attending college, it’s likely to be a sound investment for most students.
So, why all the angst about student loans? One important thing that every McCombs student learns about financial leverage is that it increases risk: The $2,000 that I expect to earn is hypothetical, but the $1,000 I borrowed and will have to pay back is not!
The Obama administration’s new initiatives for student loan repayment help reduce that risk by indexing payments to earnings and eventually forgiving loans for those in low-paying and public service jobs who repay responsibly. So, even if a student’s passion turns out not to lead to one of those $20-per-hour jobs, these changes can help ensure that a college degree is still a good investment.
Many policy issues around student loans remain to be addressed, including the promotion of excessive borrowing by for-profit colleges and the misuse of student loan funds by students. But, by helping to reduce the risk in the investment equation, the president’s new initiatives are a step in the right direction.
Platt is the associate dean for undergraduate programs at the McCombs School of Business.