One of the first steps of student loan reform is preventing overlending, the predatory practice of loaning people more money than they can ever pay back.
There are many student loan horror stories, and some of them involve kids who somehow borrow over 100 grand for college, way more than is necessary, and walking out of school having already borrowed enough to buy a house. It's easy to blame the student, but this is also the fault of a system that happily lets you accumulate debt beyond your means: if we reform the student loan system, such an excessive loan won't even be possible.
But wait: if 100K in student loans is excessive and irresponsible, how much is responsible? What's the most you should borrow to go to college? Or to put it another way, if we ever reform the student loan system to prohibit overlending, what will be your borrowing limit? Below the fold, I lay out some mathematics with sobering results.
First, some assumptions. Imagine a perfectly reformed student loan system, free of fees and predatory practices, one that will defer all your interest until you enter the job market. This system will only lend you what you can realistically pay back, with all the numbers agreed upon up front, with a payment plan.
Now we need to define "realistically pay back": how long do you want to be paying off your loan, and what percentage of your monthly take-home pay are you planning to spend on your loan payment? I'm going pick "30 years" and "15 percent" as a starting point and work down.
Both of those numbers should give you pause. 30 years means you'll still be paying for your college education when your kids are going to college, and 15% means that your monthly student loan payment will probably cost more than your car payment. I'm picking large numbers here to get an upper bound on what you could borrow.
Combine these two parameters with an interest rate, and we can figure out how much you can reasonably borrow as a multiple of your annual take-home pay. Here are the results for a range of rates:
Your borrowing limit, as a multiple of your annual take-home (after tax) pay, if you pay back 15% of your monthly paycheck for N years:
Interest rate | 30 years | 20 years | 10 years |
---|
6.0 | 2.08 | 1.75 | 1.13 |
6.5 | 1.98 | 1.68 | 1.10 |
7.0 | 1.88 | 1.62 | 1.08 |
7.5 | 1.78 | 1.55 | 1.05 |
8.0 | 1.70 | 1.49 | 1.03 |
The long and short of this table is a simple and important rule: figure one year of your take-home pay after you get out of college. At most you should borrow between one and two times that amount, if you plan to pay it back over the next few decades. Again, that is assuming you really dump 15% of take-home pay every month, and have an ideal loan free of snares and pitfalls.
Now the next question: is that a lot? Is it enough? Well, no, not enough to pay for a four-year degree end-to-end. Even at a state school with cheap in-state rates, tuition plus room and board can range from 60-80K for four years. Now, suppose you land a job grossing $46000 upon graduation, a fair guess for a median salary among college graduates. Your take-home will be well below 30 grand. According to this table, you can't borrow enough to pay for the degree, even the cheap one.
This is the next important rule about borrowing for college: never borrow enough money to completely pay for college. That is too much money. If you're broke, you're not going to do a full four-year degree entirely on loan. You're going to move out of the dorms when you can, you're going to work summer jobs to pay some of the tuition yourself, and a part-time job during the year to cover your rent. On top of this you can cut more dramatic corners if necessary, although it usually requires that you plan them well in advance.
Bear in mind that this is not advice for dealing with today's broken student loan system. This will be true even if we reform it, true for as long as the compound interest formula works. The reality of college is that if you're broke, a reasonable student loan will cover maybe half of a four-year degree in-state, and the rest must be taken out by cutting corners and working through college.
But wait, it's not all that bad
I'm making some stiff assumptions in this analysis. The first is that you must pay it all yourself, that you won't have anyone to help you. Some don't, but many students have assistance from their parents: even if they don't have money to send you to college, they can help pay part of your loans. After all, you are no longer eating them out of house and home, so they'll have a few bucks to spare.
The second factor is inflation. Even if your salary remains stagnant relative to inflation, your required loan payment will become a gradually smaller fraction of your paycheck. 10 years down the road, your monthly loan payment may shrink from an intimidating 15% of your paycheck to a luxurious 12%.
Your first defense against perpetual indebtedness is having a plan, and knowing exactly what you're signing up for. Sadly, many students are so insulated from their loans that they can't even tell you what they borrowed, much less how long it will take them to pay it back. To survive, you must understand your situation completely before you agree to it. This includes an understanding of how much you should borrow, what sort of payback that will entail, and just how little or how much that will cover your expenses.