{"id":1541,"date":"2014-09-27T16:00:38","date_gmt":"2014-09-27T20:00:38","guid":{"rendered":"http:\/\/blogs.darden.virginia.edu\/brunerblog\/?p=1541"},"modified":"2018-08-08T11:31:19","modified_gmt":"2018-08-08T15:31:19","slug":"time-to-fix-your-debt","status":"publish","type":"post","link":"https:\/\/blogs.darden.virginia.edu\/brunerblog\/2014\/09\/time-to-fix-your-debt\/","title":{"rendered":"Time to Fix Your Debt?"},"content":{"rendered":"

S<\/span>tudent 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<\/a> in America. In previous postings (see this<\/a> and this<\/a>) 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\u2019ve heard about have dealt with people who don\u2019t 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\u2019t 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\u2019ll hear fewer of these stories. <\/p>\n

Will there be an \u201cAct II\u201d of the student loan crisis? Will rising interest rates throw more student borrowers into distress? What should student borrowers do to protect themselves? Let\u2019s consider this situation. <\/p>\n

The Context<\/b> <\/p>\n

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\u2014how fast and orderly that occurs is anyone\u2019s guess. In consequence, student loans whose interest rates \u201cfloat\u201d 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\u2019s baaaack! <\/p>\n

Well, maybe yes and maybe no. <\/p>\n

Who is exposed? How exposed?<\/b> <\/p>\n

\u201cAct II\u201d 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<\/a> 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\u2014and business. Such students are highly desirable to America\u2019s universities: they are hardworking, dedicated, and pioneering (see my earlier post<\/a> 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. <\/p>\n

The pain of rising interest rates is really a matter of how much debt relative to the student\u2019s income. Here\u2019s 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\u2019s say that Jeanne earns $100,000 per year upon graduation; Greg earns $50,000 per year.<\/p>\n\n\n\n\n\n\n\n\n\n\n\n\n\n\n\n
 <\/td>\nJeanne<\/td>\nGreg<\/td>\n<\/tr>\n
Student Loan Debt<\/td>\n$100,000<\/td>\n$100,000<\/td>\n<\/tr>\n
Annual Salary<\/td>\n$100,000<\/td>\n$ 50,000<\/td>\n<\/tr>\n
 <\/td>\n<\/tr>\n
Debt Service before (5%, 10 years)<\/td>\n$ 12,720<\/td>\n$ 12,720<\/td>\n<\/tr>\n
Debt Service after (8%, 10 years)<\/td>\n$ 14,560<\/td>\n$ 14,560<\/td>\n<\/tr>\n
 <\/td>\n<\/tr>\n
Change in Debt Service<\/td>\n$ 1,840<\/td>\n$ 1,840<\/td>\n<\/tr>\n
 <\/td>\n<\/tr>\n
Debt Service\/Salary before<\/td>\n13%<\/td>\n25%<\/td>\n<\/tr>\n
Debt Service\/Salary after<\/td>\n15%<\/td>\n29%<\/td>\n<\/tr>\n
 <\/td>\n<\/tr>\n
Increase in Debt Service as a % of Salary<\/td>\n2%<\/td>\n4%<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n

<\/p>\n

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. <\/p>\n

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.   <\/p>\n

Getting a \u201cfix\u201d<\/b> <\/p>\n

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\u2019s interest burden to be manageable, you could lock in today\u2019s interest rate by swapping your floating rate debt for fixed-rate debt. To \u201cfix\u201d 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. <\/p>\n

In the abstract, the question of whether to \u201cfix\u201d 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\u2019s 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\u2019t the only thing that matters. <\/p>\n

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 <\/i>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\u2019ve 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\u2014the problem is more complicated than that. <\/p>\n

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.] <\/p>\n

Fortunately, years of observations about how markets price securities tell us that the student debtor who holds a floating rate loan will find it more<\/i>advantageous to \u201cfix\u201d the loan if:<\/p>\n