Financial Aid & Loans: Considerations for Parents & Students, Part 2
Before we go further, we need to explore debt payments. With each mortgage payment on my house, I pay off some interest and retire some principal (the amount I borrowed). Since my monthly interest charge is based on the outstanding (yet-to-be-paid) principal balance of my loan, it follows that, as the balance gets paid down, the amount of interest in each successive payment shrinks and the amount of principal in each payment rises by an equal amount. Thus, my initial mortgage payments consist mostly of interest owed and retire (to my mind, much too) little principal, but for my final payments, the order is reversed; I’m now paying mostly principal and very little interest. Plus, if I can pay off a large chunk of principal ahead of schedule, not only does the loan get paid earlier, but subsequent loan payments will also retire a larger percentage of principal (the amount I pay for each future installment remains unchanged, however). Early (or faster) payoff spares me (the borrower) from having to make additional interest payments, and saves me a chunk of money I’d otherwise have to shell out over time in interest payments on my loan.
Besides applying to mortgage payments, this same form of loan retirement -- with the proportions of interest falling and principal rising through successive installments -- applies to other debt as well, including student loans for college. Suppose, after you’ve applied to a college for admission and financial aid, that you’ve been offered admission and the college informs you, As part of our financial aid package, we will award you a grant of X dollars per year, and you will incur a loan of $5,000 per year for each of the four years you will be attending, meaning you can expect to incur $20,000 in debt altogether. One way to think about this is that it’s like buying a car when you finish college -- which is what many students do, so we’ll discuss a loan as though you are paying for a car.
But wait; there’s yet a little more:
My initial principal loan balance was about $28,000. I didn’t get any correspondence from my loan provider until I was a senior in college. When I got an email that said I had accrued $3,500 in interest, it felt huge to me. I definitely made more than that through on-campus jobs and paid internships during school, and I could have put that money toward my student loans. If the provider had been sending notices, maybe I would have been sending in money sooner.
Many students don’t understand that interest is accruing on your loans from your first day of college. Once the grace period expires, that interest is added to your balance, so then you’re paying interest on the interest (emphasis added). -- -Madeline Barr, Chicago Booth Magazine, Fall 2016 ed., pps. 10-11.
From Ms. Barr’s description, it is clear that the meter for interest on borrowed funds starts ticking the moment you register for your first year of college. And accrued interest is one additional component of a student loan that you should be aware of. And, oh yes, the loan provider is not the college.
OK, then, so how much should I borrow? How big a loan do I take out? (Alternatively, how much should I pay for my new car? Or perhaps more accurately, how much car do I want to buy -- a Honda Civic or a Rolls Royce?
For this question, there’s no pat answer, so I’ll offer up a parable instead. Over a century ago, an associate of J.P. Morgan had been speculating in securities by buying them on margin, meaning he bought stocks with borrowed money, and he’d borrowed so much that he couldn’t sleep at night because he worried excessively over how precariously far out on a financial limb he had climbed (bankers term this condition highly leveraged). He mentioned his sleeplessness to his boss and asked how to cure it. J.P., ever practical, replied, “Sell stock until you are able to sleep comfortably.” (Bankers and economists have a term for this, too; they call it risk tolerance.) Note that J.P. did not specify how many dollars worth of securities his associate should unload; that decision, he wisely left to his associate. And so it is with debt to finance a college education. Perhaps also worth noting, investor Warren Buffett has a different view on borrowing for speculative purposes, “It’s only when the [financial] tide goes out that you learn who’s been swimming naked.” Clearly, Buffett, who addresses himself to all who would emulate J.P. Morgan’s associate, is no fan of debt, and had he been J.P. Morgan’s associate, the conversation over speculating on margin would not have taken place. Whoa! Wait a minute: is taking out a student loan a form of speculation? Well, yes, it is. By applying for the loan, the borrower implicitly places a bet that, after he graduates, he will do well enough financially to not only repay the debt but to accumulate much more wealth as well.
If you are pondering how much debt to take on to help pay your way through college, I couldn’t begin to suggest how much you should borrow, but if borrow you must, J.P.’s advice seems timeless. If you can live with the debt, then take it on, and if you cannot -- if the amount seems so unduly burdensome that worrying about it would keep you awake at night -- then think seriously about attending a college that features a more robust financial aid program or a lower term bill, someplace for which the loan will be lower, or for which there will be no loan at all.
Our discussion has highlighted three two key points: how student loans are structured; and, if the borrowed funds are used wisely and repaid, college loans can make an enormous difference in a student’s future -- the tricky part is determining how much to borrow. In the process, you have been given a free tutorial in finance, which is all about borrowing and (its flip side) lending.
And this brings us to the point in the admissions cycle I came in. After early admission decisions get handed out, admissions committees across the country will hunkers down to the selection of the remainder of next fall’s entering class. But there’s no need to go further because we’ve already covered this.
In closing, I hope I’ve helped explain how the admissions process works for selective colleges and universities, and maybe debunk some myth. The old adage that an ‘informed buyer makes the best buyer’ applies fully here. This by itself won’t earn you college acceptance; that you must do through your efforts in and outside the classroom. But I hope it have given you a framework within which to understand the admissions process and thereby helps make the task of applying to college that much sharper and clearer.
Dear Readers, I sincerely wish you the very best luck in your college admission quest. You will make new, lifelong friends. Your academic accomplishments will make your family proud, and will reflect great credit on your family, your teachers and your school. You may endure an impossibly difficult academic regimen, and when it is finished, you will be amazed at what you have been able to accomplish. I believe that for many of you, regardless of where you end up in college, you will take a class or come upon a teacher who transforms your life. And for some, college may open up and gain you entry into a world which you could scarcely have imagined to exist. Best of all, perhaps a few of you may someday be motivated to serve as alumni interviewers for your college!
William B. Parker, University of Chicago (MBA-1978)
Member, University of Chicago Alumni Schools Committee since 1983.
Cape Coral, Florida