Student debt has been in the news a lot lately, mainly because of its sheer size: some $1.2 trillion of it is outstanding, more than any other class of consumer loans in America. In previous postings (see this and this) I have argued that borrowing to finance your education is a rational strategy, given the high return on investment from getting a solid education and a degree from a serious school. Yet the media abound with stories of students and graduates who borrowed and today find themselves in financial distress. The problem stories we’ve heard about have dealt with people who don’t finish their degrees (about 63% of all college and university students who enroll), who graduate from diploma mills that do little to screen and prepare students for life, or who don’t make use of school to truly strengthen their human capital. Though we wish these borrowers had shown more savvy and commitment, they also deserve our sympathy: they learned too late that debt is a remorseless ruler. One hopes that as the American economy gains strength, we’ll hear fewer of these stories.
Will there be an “Act II” of the student loan crisis? Will rising interest rates throw more student borrowers into distress? What should student borrowers do to protect themselves? Let’s consider this situation.
Fed Chairman Janet Yellen has announced the likelihood that the Fed will cease buying U.S. Treasurys in October. This is the end of Quantitative Easing the artificial depression of interest rates that was intended to stimulate the growth of the American economy. It is expected that interest rates will rise as the Fed unshackles the debt markets—how fast and orderly that occurs is anyone’s guess. In consequence, student loans whose interest rates “float” with market conditions will become more expensive. The portion of those graduates who have been meeting their obligations, but doing so with difficulty, might sink into distress. Just when we hoped that the student loan issue would go away, it’s baaaack!
Well, maybe yes and maybe no.
Who is exposed? How exposed?
“Act II” will likely have the most relevance for a fraction of student loan borrowers. One expert told me that of the $1.2 trillion in student loans, maybe $150 billion of it is floating-rate paper. Who are these debtors? A recent study by Brookings suggests that graduate students account for a big portion of the growth in student debt. And much of the student floating rate loans are issued in the private debt market. Who borrows there? We have less clarity about this market. But we can guess that it includes people who are shut out of the U.S. government grants and loans, which are mainly fixed-rate and which exclude foreign citizens. International students have grown in significance as a clientele of American graduate degree programs, especially in math, science, engineering—and business. Such students are highly desirable to America’s universities: they are hardworking, dedicated, and pioneering (see my earlier post on international students). In short, international graduates of American graduate schools may be like the canary in the coal mine, a barometer of possible distress from rising interest rates.
The pain of rising interest rates is really a matter of how much debt relative to the student’s income. Here’s a rough example: suppose two students, each of whom accumulated $100,000 in floating-rate debt to finance a graduate degree. But the two graduates follow very different career paths. Let’s say that Jeanne earns $100,000 per year upon graduation; Greg earns $50,000 per year.
|Student Loan Debt||$100,000||$100,000|
|Annual Salary||$100,000||$ 50,000|
|Debt Service before (5%, 10 years)||$ 12,720||$ 12,720|
|Debt Service after (8%, 10 years)||$ 14,560||$ 14,560|
|Change in Debt Service||$ 1,840||$ 1,840|
|Debt Service/Salary before||13%||25%|
|Debt Service/Salary after||15%||29%|
|Increase in Debt Service as a % of Salary||2%||4%|
The extra $1,840 per year may not be stressful for Jeanne; but Greg will feel the pinch. Jeanne is cushioned by her larger salary; Greg may have to make sacrifices.
This little example overlooks one other important factor: borrowers whose credit rating is decent or has improved will find it desirable to refinance their loans. Most students in school look the same: no earnings. Therefore, one size fits all; the borrowers with strong prospects subsidize the weak. After graduation and a year or two of earnings, it makes sense for the strong debtor to consolidate into a cheaper private fixed rate loan. Strong earning graduates can “afford” to give up some of the “social insurance” such as loan forgiveness, etc on the federal loans in return for a lower priced private loan.
Getting a “fix”
If you borrowed floating-rate debt, what should you do? Hoping for a government bailout is wishful thinking. Perhaps you could turn to friends and family to help you pay off the loan. Or perhaps you could sell some assets to pay down your debt. Or, if you find today’s interest burden to be manageable, you could lock in today’s interest rate by swapping your floating rate debt for fixed-rate debt. To “fix” your floating-rate loan is a matter of borrowing a new fixed-rate loan and using the proceeds to pay off the floating rate loan.
In the abstract, the question of whether to “fix” your floating-rate debt hinges on a simple comparison: are you better off with fixed or floating rates? Usually, this translates into looking at the cost of borrowing under either type of loan. On the Internet, you can find calculators that will tell you the effective interest rate on a loan. You might think that it’s as simple as comparing the fixed and floating rates of interest. Generally, interest on fixed rate loans is higher than on floating rate loans of comparable term. One might conclude that the decision is easy. Not true. Price isn’t the only thing that matters.
You should also care about risk. Under the floating rate loan, you bear the uncertainty about the future movement of interest rates. And as of today, you face asymmetric risk. Interest rates are at historic lows and have only one way to go: up. With the fixed-rate loan, you have immunized yourself against the uncertainty of future interest rate movements. In effect, you’ve bought an insurance policy in your fixed-rate loan, and that insurance is valuable. Because of this, fixed-rate loans often carry a higher rate of interest than do floating-rate loans: the extra bit of interest expense is like a premium on an insurance policy that immunizes you against rising interest rates. Thus, the simple comparison of the nominal fixed and floating interest rates on student loans makes no sense—the problem is more complicated than that.
Estimating the value of the insurance in a fixed-rate loan entails making assumptions about the future path of interest rates. Doing that requires math and modeling skills beyond the reach of most debtors. [Hint to the MBA reader: this kind of analysis requires a robust simulation model.]
Fortunately, years of observations about how markets price securities tell us that the student debtor who holds a floating rate loan will find it moreadvantageous to “fix” the loan if:
You have a lot of debt, relative to your current income.
You have a lot of uncertainty about future interest rates.
Or you believe that interest rates will rise, rise a lot, and/or rise suddenly.
The loan is longer, rather than shorter, in duration—ten years or more certainly qualifies.
You can find a fixed interest rate that fits your budget today.
The special fees and other costs to refinance are not onerous.
Your own income stream (salary plus bonus, for example) is not so stable and/or is unlikely to grow.
You don’t have many assets on which you could draw for support if interest rates spike upward.
Under such circumstances, the insurance embedded in a fixed-rate loan will be worth a lot. In any event, the right course of action will depend on your individual circumstances. If any of this describes you, it could be worthwhile to see a financial adviser to gain a detailed assessment of the risk and cost of loan alternatives.
Why fix now?
Still, I can hear the objections. Swapping fixed for floating-rate student loans looks like betting on the future path of interest rates. Even sophisticated finance professionals say that forecasting interest rates is a fool’s errand. And some economists believe that rates won’t rise when the Fed unleashes the debt markets because bad economic news in Europe, Asia, and Latin America suggest that deflation has a powerful grip on the global economy: interest rates could stay low for years. Even America’s growth rate seems unlikely to juice up the debt markets. GDP growth is anemic. The dollar is strengthening, which will dampen exports. The stock market is at historic highs and seems more likely to subside than grow. And political gridlock in Washington, at least through 2016, assures us that fiscal stimulus is unlikely. All of this is not a scenario for rising interest rates. Thus, objectors would say that if you have floating-rate debt, don’t worry, be happy.
My response is that most consumers don’t know what they don’t know. Would you rather eat well (with lower interest rates) or sleep well (immunized against higher interest rates)?  If we’ve learned anything from the Global Financial Crisis and Great Recession, it is that history tends to repeat itself, or at least rhyme; that bearish financial trends can move faster than you can outrun them; and that conditions can remain bad longer than you can remain solvent. If this discussion makes you uneasy in some way, then now could be a good time to fix your floating rate debt.
[Disclaimer: I am a Dean of a business school who cares about his students and graduates. I’m not a licensed investment or financial adviser. The reader should seek the counsel of an adviser who can apply sophisticated modeling to one’s specific circumstances.]