Pages

Tuesday, November 25, 2008

Guaranteed Gains

The study of economics generally relies on the assumption that people make rational decisions. Of course, people don't, which forces economists and people who work in business fields (or really, everyone) to take that into consideration in everything they do.

When someone is in college or graduate school, they are offered the opportunity to take out student loans which tend to have a low interest rate after college, are interest-free while you are still in college, let you choose how quickly you will pay it back, and have other advantages at later times (say, the ability to postpone payments for a year without penalty if you are unemployed). All in all, they're mutually beneficial to both the people taking them and the people giving them, and are one of the better investments the United States tends to make in its citizens. [Note this is only in reference to subsidized loans. Unsubsidized are a completely different case which is far more complicated.]

The question a typical student faces when starting college is whether to take out loans or not. For some, there is no choice: They must. For the rest, there is much to factor in. If a person's purpose in taking out loans is to spend it on non-necessities, they should never take out the loan. If a person is not sure what they will use the money for, they should also not take the loan - odds are in the end, they will spend the money much like the first group. A person should only take out loans if they have a clear plan that they will follow as to what to do with the money.

Many people - generally those who are more comfortable, but not exclusively - do not need the money at all. Perhaps their parents are paying; perhaps they have a scholarship; perhaps they have both; perhaps they are working on the side. Often, people automatically react to the idea of taking out loans quite negatively: Why pick up debt if you don't have to? While normally this might be true and even laudable, it does not always make sense.

If someone came over to you tomorrow and asked you for a $10 bill in exchange for two $5 bills and a $1 bill, you would likely look at them suspiciously and ask if the fives were real. After a few minutes of trying to ascertain what the catch was, you'd either take the money or tell the person that such a deal makes you uncomfortable and walk away. Yet when offered the same opportunity from the government of the United States, people blanch at the very idea. (Note the term opportunity.)

A person who does not trust him or herself to not touch the money should not take the loan. A person with moderate self-control, however, would be able to take the loans and stick them immediately into CDs (Certificates of Deposit) with a trusted bank, Treasury Bills, or some other guaranteed instrument. As an example, a 1-year CD with INGDirect would earn 4%. If a person took out $2,500 in year 1; $3,500 in year 2; and $5,500 in the last two years of college, they'd have borrowed a total of $17,000. If they invested all of it in those 1-year CDs and then took the lump sum and paid it back before any interest kicked in, they'd have about $18,500, or a net gain of about $1,500 after their loans are paid off. This gain would be tax free, guaranteed, and rather uncomplicated. This is by taking the absolute safest route, with no real risk of any kind. Adding in risk could result in higher rewards, but this is certainly not wise as these are loans that a person wishes to repay.

On the last post, Sephardi Lady - who authors Orthonomics, the blog I most often recommend to people - commented:
I'm old fashioned. I do not think it is a good idea to take out debt, even if the numbers crunch positively.
In terms of giving advice to people in general or communities as a whole, this is the wisest route. Most people who hear that it could be smart to take out loans will likely end up spending it - even if mostly on worthwhile things - instead of investing it safely and wisely. But if someone understands how and why the numbers are crunched positively, and will actually do so, then there is no reason they should not. Simply saying that "debt is bad" ignores its potential utility for the positive and its ability to help people get yet another small boost to start their lives. Moreover, the lesson someone can learn from that simple but mostly untouchable example of how interest can help or hurt a person will prove to be very useful throughout their lives when considering other debt or investments. This, too, should not be underestimated.

Not all debts are "bad", just as not all investments - even sound ones such as houses - are "good". It is important to understand which is which and why, on both sides of the coin.

Powered by WebAds