Van Cott: Student Loans

February 20, 2020

by Norman Van Cott, Ph.D.

College students currently graduate with an average student loan debt of $30,000. At a 4 percent interest rate, monthly payments of $304 ($3,648 per year) retire the debt in 10 years. In all the current brouhaha about the college loan crisis, an important cost to borrowers is unmentioned. To wit, the burden of loan repayment following graduation no doubt delays graduates beginning personal retirement programs.

Financial counselors have long stressed that the “miracle of compounding” becomes increasingly powerful the longer any funds are held. Save early is the counselors’ motto. Not for new college graduates faced with loan repayment. For example, what if the holder of the $30,000 student loan, who pays it off in 10 years, delays implementing a personal retirement program for 10 years? Does it make a difference? Yes, a big difference. How much?

There are numerous ways to configure examples of the consequences of this delay. To keep things simple, consider two scenarios. First, ask what the average college graduate paying $3,648 per year on his or her loan could expect to accumulate by retirement had that same amount been annually invested and held in the stock market (say, in an S&P 500 index fund). Second, suppose one adopts the same investment program delayed by 10 years on account of loan repayment.

To this end, it turns out that the average annual return in the stock market since 1928, as measured by the S&P 500 index, is about 10 percent. Making the calculations by hand is tedious. For example, the first year’s payment will grow to $3,648 x (1.1)10 by the end of 10 years. Likewise, the second year’s payment grows to $3,648 x (1.1)9 by the end of nine years, and so on. (Various websites can assist.)

In either scenario, the graduates end up with $63,948 at the end of 10 years of investing $3,648 per year. However, the loan re-payer realizes this $63,498 10 years later than the non-re-payer. Were the non-re-payer to allow his/her $63,948 to accumulate for another 10 years so that the two were at the same time, the non-re-payer’s S&P account would be worth $165, 864 — more than $100,000 greater than the re-payer’s account.

Alternatively, suppose at the end of 10 years of investing, both individuals let their S&P accounts accumulate until they reached the retirement age of 65. Assume both graduate at age 22.

The non-re-payer’s account would accumulate another 33 years, the re-payer’s account 23 years. When both reach age 65, the non-re-payer’s account would be worth $1,485,202; the re-payer’s account $572,609. Yes, the difference is almost $1,000,000. Saving earlier rather than later matters. No wonder Albert Einstein labeled compound interest the “eighth wonder of the world.”

What makes this story even more unfortunate in my view is that the increase in college costs tracks the increase in government support for education.

It is these extra dollars that fund the widely observed growth in college and university administrators (associate provosts, assistant provosts, associate deans, assistant deans and so on). Students end up with an administrative-laden education at the expense of less lucrative financial futures — a poor tradeoff in my book.

T. Norman Van Cott, Ph.D., professor of economics and adjunct scholar of the Indiana Policy Review Foundation, was formerly chair of the Ball State University Economics Department. A version of this article was published by the Foundation for Economic Education.


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