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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.

12 comments:

  1. Since I'm old fashioned, the idea will be a hard sell, although it never hurts to try.

    I really dislike the idea of building both sides of the balance sheet. It convinces the borrower that they are making money, when they are really setting themselves up for a potentially sticky situation.

    Many people I know who are debtors have themselves convinced that they are quite responsible. I would bet the more responsible go by the advice of chazal to never trust oneself until their dying day. While I believe chazal was looking at the issues of the yetzer in terms of keeping hilchot yichud, I think the advice could be extended to taking on debt, experimenting with gambling, etc.

    I'm not going to fly into a tirade about credit cards. I do use a credit card, although I pay it off each month in full and I enjoy my cash back. However, like I said in the other comments, if you are going to use a credit card, I would wait until you have some established spending patterns, a budget, and an emergency fund. Too many people think of their credit card as an emergency fund.

    Back to the student loan scenario (and you are the first to promote the idea, nor the last. In fact, not too long ago my husband and I were asked out opinion of a similiar "money making" scenario involving a credit card cash advance a 0% APR for 1 year).

    I can see the following scenario happening:

    An 18 year old hears of this idea and wants to make some cash. In his mind the potential thousand or few thousand is big money. And he thinks he will have no problem putting the money away, being paid interest, and then turning around and returning the principal. And interest free loan sounds great to him.

    But let's imagine for a moment:

    Sometime towards the end of college, he is introduced to a girl and they are headed to an engagement. He wants to impress her and takes her out for nice dinners, buys her jewlery for the engagement, etc.

    He feels like he has some cash to spare. After all, it is his senior year and he has been building up his assets. Our chatan even has taken on some work and has made a good amount of pocket money. He believes his investment income is tax free, but knows little about the tax system. As a dependent, he is surprised that his passive income pushed him over the line and now he owes taxes on money he thought was 'gravy.' Setback number one. But he pays up the taxes (state and city too. . .who knew that the state and city can eat money at a lower threshold than the feds) and is back on track.

    Now the wedding comes and, like many other chatanim, he and his kallah decide a one year stint in Israel at Yeshiva would be the best way to spend their shana rishona.

    Student loans are deferable, right? He will have a small can work as a therapist with special needs kids.

    They defer paying back their student loans. And the money is still in tact and is still growing.

    But soon his wife is pregnant. And they need a bunch of stuff. And her job isn't working out quite as planned. His stipend doesn't seem to be stretching as far as they thought it would stretch. So they dip into their "savings."

    After a year, they return to America. The student loans are still outstanding, and what is left in "savings" isn't enough to pay off the loans, plus put down a security deposit, 1st months rent, put down a deposit for the daycare, etc.

    What seems like a good idea, might not seem like such a a great idea in hindsight.

    Oh. . . and the young couple returns to a down economy. Finding a job isn't so easy and there is a sizable gap, but the loans can't be deferred any longer, and the loan debt is now growing. It seemed like it would never accrue interest. That wasn't part of the plan. The money was going to be there to pay them off.

    I never though I'd have something positive to say about credit card debt. . . . but here it goes: when debt is building on a credit card, it has its own line item and as the interest charges rack up, it can create an urgent situation.

    Student loans, on the other hand, can be deferred and lack a sense of urgency. And, yes, I've seen couples defer them after they marry to spend a year in Israel. The part about ends not meeting in Israel is also something I've seen.

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  2. why would the gain be tax free? why wouldn't the $1500 of interest income not be taxed as all interest income is taxed?

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  3. Anon - I was assuming a student with little to no income, so it's not coming close to pushing them over the edge. But you're right - it would be interest income.

    SL - As soon as the person "thinks they have extra to spend", they're making a mistake. The same logic can be applied to a person who uses a credit card and pays it in full every month - the first time they're put into a situation where they can be tempted to spend for a "worthwhile" cause, they spend more than they'll be able to pay off on that credit card. The difference with the student loan example is that it's far less likely to happen, if only because this is the sole purpose it's there and because it's locked into a CD where it can only be touched at a break period.

    That said, I do understand the reluctance, as noted in the post, to build balance sheets this way; however, it doesn't mean it isn't a good idea for those who do have the control. The borrower IS actually making the money.

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  4. Um, you're assuming they offer up to $5k interest free. They don't. At least, not to me. Most of my loans are unsubsidized. The subsidized ones don't add up to nearly that much. And ING gives 4%? I don't know of anyone offering 4% at the mo.

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  5. Bad4 - In undergrad, they have to if you're full time, I believe. The actual amounts (I copied this from their site, only the relevant parts):

    If you're a dependent undergraduate student , each year you can borrow up to:

    * $5,500. No more than $3,500 of this amount can be in subsidized loans.
    * $6,500. No more than $4,500 of this amount can be in subsidized loans.
    * $7,500. No more than $5,500 of this amount can be in subsidized loans.

    Numbers are higher for independent students, but the subsidized numbers are the same. I'd actually thought they were lower when I wrote the post for the first two years, hence my examples.

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  6. And yes, ING gives 4%. I saw one place higher, but didn't recognize the bank (I think a regional one). Most places are 3.75 or higher, I believe. And this always changes based on the current rates. Interestingly, they should be higher than the rate a person would get on their loans at that time, if I'm not mistaken (though I may be), which means if you've locked a rate on loans and can lock a rate on CDs you'd be better off continuing to keep the loans and the CDs and time the CDs to make payments on the loans. You'd be making money in perpetuity (or until the money runs out, anyway).

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  7. SephardiLady lists some things that can go wrong with this plan. Ezzie counters that those examples are mistakes that by definition of how he set up the plan would not happen. Ezzie is correct; his plan calls for a person to be responsible and not make those foreseeable errors.

    A danger, however, is that a person learning of this plan would think it is a good idea and try to implement it when he does not "qualify" as a responsible person with the necessary self-control and also lacks the understanding of such things like the taxes involved.

    That is to say, I do not disagree that by definition the plan disincludes such mistakes, but there is a problem in promoting it, because most people will make such mistakes and will lack some understanding of some detail.

    And even the most responsible people can end up making other, unforeseeable mistakes. Yes, the situation is more rigid than one of unsecured credit, but things can happen, and a move that seems benign to the most informed person can go wrong.

    That said, let's say a borrower makes none of these mistakes, not the naive ones and not the informed ones. Things can still prove disastrous.

    There are plenty of situations for which the borrower, now with this pocket of savings tucked away, which he knows is earmarked for repayment of the loan at the proper time but to any financial examiner is simply plain old available savings will end up having to use those very savings to pay for something simply because he has them instead of qualifying for a lower payment or a grant or an opportunity.

    Basically, having money on hand that cannot actually be used can be to a person's disadvantage in many ways, some emergent, some general.

    Also, that borrower who qualified for $2,500 the first year could very well have qualified for higher amounts the subsequent years to make up for a difference in grants! The financial aid office will, on the application for the second year, see the savings and consider that available for tuition and lower the grants given expecting the savings to be used, not left earmarked for repayment. The student had been perfectly eligible for the grants, but now because of this scheme, he loses the grants and will in fact end up having a loan to repay, as he will either need to use the savings that were seen as available funds for real costs or he will need to take the second offered loan to pay for real costs.

    Also, it's possible the loan amounts offered will go down and not up right along with the grants.

    If the student ends up having to work extra hours to pay for the difference, this defeats the idea of an unneeded loan.

    The idea to repay the loan after a year right before the subsequent application won't work. For a traditional school year, a loan is dispersed in the fall, and then financial aid forms are submitted a mere six months later. Financial aid offices require tax returns, and honest tax returns will reflect interest earned over the course of the year, so it won't matter that the savings are gone. The financial aid office will also be able to see that the loan has been repaid to the loan company.

    Further, the loan companies expect the repayment of all the loans to begin together after the student has finished or left school, complete with exit interview; there can be difficulty in trying to repay one loan while applying for the next.

    Okay, so, given all that, it really seems the borrower is not going to make $1,500, as he will not be able to both qualify for each of those loans while not needing any of them and keep them invested from disbursement until the end of school enrollment instead of repaying.

    Okay, but let's say the borrower weighs all this and still decides to pull this scheme and, somehow, some money is netted. Let's say $600. It's not going to be $1,500 for reasons explained above.

    This may or may not be tax-free, depending on other income -- remember that this student is probably working so as not to need loans and of course might have other assets -- and dependant status. Interest earned during the last year will almost certainly be taxed assuming full-time employment is gained that same year.

    Remember that taxes deducted from interest each year leaves less interest to compound in subsequent years.

    Of course, even taxed, $600 is a nice bit of unearned income, but is it worth it?

    Besides taxes, there is tsedakah. Now, it is a nice benefit that this extra earned income would mean extra funds for tsedakah, and it would be a shame to decide against earning extra funds simply because deducting tsedkaah form it leaves not enough to make it worthwhile. Here, however, there are other factors.

    So, taxes, tsedakah. Still, say, above $500 left. Okay. Is that worth it?

    How about once photocopying and postage is taken into account?

    Then there is aggravation and having more things to look after.

    What about having an extra bit of paperwork to collect for the taxes?

    Having to make time for entrance and exit interviews?

    Needing to be aware of yet one more deadline, in this case for repayment?

    Keeping track of financial documents and contact information and important letters during a time when lots of moving about will probably be happening?

    Each of these is minimal, yes, and commonly done, but they do add up and can cause stress.

    Above all, what about the worrying that SOMETHING COULD GO WRONG.

    For the person who just feels uncomfortable with the debt, even with the money right there to pay it back, is all this really worth it, for 500-some-odd dollars and all this extra aggravation and worry?

    One last thing to consider is the ethical implication. It is subsidized loans that are being discussed, loans subsidized by the government. This is why the loan is interest-free for all those years while enrolled in school (and why the interest is low during repayment). This scheme costs the government -- the taxpayers -- money. Isn't this another example of a government program that is there for people who need it but shouldn't be used if it isn't needed even if it would be more profitable for the individual to do so? Is this ethical? Is this halachic? Does this fit with political views expressed previously on this blog?

    It is an intriguing idea. I've often thought that if I were to come into a little money, it might be a good idea to keep the money in an account that earned interest higher than the low interest rate charged on my remaining student loans, and have the monthly payments taken directly no longer from my checking account but rather from that account -- this part would be slightly more complicated with a CD -- while the declining balance earns a little interest income. It is a nice idea, a good opportunity, but the feeling of being debt free even if the balance sheet works in my favor and the fear of somehow screwing it up would all probably win out. Eh, I don't have the money to do that, and I wouldn't make even $100 in the end if I did.

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  8. And this always changes based on the current rates. Interestingly, they should be higher than the rate a person would get on their loans at that time, if I'm not mistaken (though I may be), which means if you've locked a rate on loans and can lock a rate on CDs you'd be better off continuing to keep the loans and the CDs and time the CDs to make payments on the loans.

    Yes, I believe you are incorrect.

    The difference between my current loan rate and the 4% CD rate is about 1%, and that's only because I qualify for some rate deductions. My base rate is certainly higher than 4%.

    A borrower just beginning to repay would not get a rate below 4% for the current year.

    Rates used to get locked when the loan papers were first signed. Now they are variable, getting reset every July. I wonder what rate ING offered on CDs five months ago. My most recent reset caught a bunch of the recent Fed interest rate decreases -- like 3% in total? -- but not the most immediately recent ones.

    Locking into a CD rate is a risk when the loan rate can jump right back up.

    Banks typically pay out at lower rates than they charge. It is only because these are subsidized loans that the rate charged on loans is not way higher than the rate paid on CDs.

    Can it really be almost twenty years since I last saw a CD yield of 8%?

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  9. (Firstly, are there one or two anons? Can you pick [a] handle[s]?)

    2nd anon first:

    Student loan rates are perhaps variable to start, but you can certainly lock them at rates. My wife's are locked at 2.9%, and that has not changed. But again, my main idea is for when the interest is 0% and the CD is whatever positive number.

    (To be continued, gotta run.)

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  10. Also, I believe ING a few months ago was closer to 5.75% (rates have since dropped), and people were really wowed, since it's been a while even for that high as you noted.

    And yes, banks pay out less than they charge; which is why this situation is the rare time where you can make money off the bank (though of course they're making it off the government or whomever).

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  11. Anon1 - Agree with the first couple paragraphs. I think the fourth offsets the small chance of the third. And to some extent, the type of people who look at this as "ooh, a money-making scheme" will probably be better off making this mistake than most others. I know that sounds harsh, but I've found that certain personality types tend to gravitate toward certain mistakes. Some are less bad. On to the 5th para. and on, because that's worth more discussion...

    Certainly if someone is eligible for grants they shouldn't blow chances at them by taking money. In my original example I was using people who already have tuition covered (whether by parents or scholarship or whatever). That would obviously be a horrible mistake that we can all agree on. Also, I'd question if money that's locked up in CDs or T-bills or similar would be considered against someone in light of its non-liquidity. From any form I've filled out, they tend to want to know what you have in liquid cash - to the point that people I know will be upset that they cashed out bonds to pay part of their tuition at the same time they're filling out financial aid requests.

    I'm not sure if/where I said that the loans would be paid back each year; in my scenario, I intended that they take out each year but only pay it all back after graduation before the interest kicks in. The calculation of $1500 is correct (though in truth more like $2000 since I was short $1k each of the first two years). Re: Interest - most of the interest is earned in the first few years when the person is a student. Presumably they aren't earning enough elsewhere to be paying tax, so the interest too is tax-free. Meanwhile, in that final year, if they graduate and start working in the fall, it's probable that the interest earned then would be taxed but negligibly. The same is true about your point about fin. aid - the actual income reported is a couple hundred each year, certainly not enough to offset aid.

    Re: paperwork, negligible. I filled out almost everything online for all of this, and loan papers take less than a few minutes to fill out. Most people are filling out most of the same information regardless. I keep track of all my loans online, and those tell me when things are due; again, rather simple.

    All in all, I think the only real difficulty I have is the final one, and I'm surprised nobody brought it up until now: Ethics. I wonder if this would be unethical or wrong in some way - if a program that is designed to let you do what you want can be used to essentially make money off the government, is that wrong?

    More specifically - the government allows loans to be used not only for tuition but for living expenses as well, and that is a rather broad definition. They also limit the amount you can borrow. Does this give you carte blanche to do it? I'm not sure. I'm surprised nobody brought it up until now, really - I think it's the strongest question on the whole idea: Is. This. Right? And I don't know that one should say "well, if you're not sure, don't do it" - I think that as it's certainly allowed, and the government would say you can do it, it gives a strong argument to the side that it's fine. (Similar to the psak we got about Dougie's takeout - splitting all you can eat - it IS permitted even if it's not what it is meant for.)

    Finally, I'll note that people DO do that with student loans and mortgages all the time (your last paragraph), so to some extent people agree with the idea all the time. It's just different allowing it to continue vs. setting out to do it in the first place in people's minds.

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  12. Also, thank you for really good, well-reasoned, and well-put comments. It's good to have good discussion. Yiasher Kochacha/eich.

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