Financially Hobbled for Life
The financial economics of grad school investment
“Financially hobbled for life”. So reads the headline from a recent WSJ article which recounts the very real financial difficulties faced by many graduates of the MFA film program at Columbia University. According to the article, in a cohort of recent Columbia film graduates, the median student loan debt was $181,000 and half of those who graduated two years earlier were earning less than $30,000 a year. My immediate reaction on reading this was “NFW”, which we all know means “Not Financially Workable”.
An annual income of $30,000 is $2500 per month (pre-tax) or $15 per hour for a 40-hour/week job working 50 weeks per year. The payment on a student loan balance of $181,000 at an average interest rate of 5.75% (the blended average of the subsidized and unsubsidized federal loan rates for graduate students) is about $2,000 per month ($24,000 per annum) if paid over 10-years or about $1300 a month ($15,600 per annum) if paid over 20-years. (The payments for Mr. Clement, shown in the photo above, would likely be about twice these amounts.) These numbers don’t work, particularly not for someone living in NY City.
The issues described in the article are not unique to MFA grad students at Columbia of course. Student loan debt is becoming a major social and economic problem in this country. By some estimates, $125 billion of student loan debt is currently in default (about 8% of the total outstanding) and 1 million loans go into default each year, including a large number of recent graduates’ loans. It is estimated that perhaps 25% of all those with student loans will default within five years of beginning repayment. These sorts of default rates makes leveraged loans look good by comparison.
Unaffordable student loan debt is disproportionately a problem at private for-profit schools and among students from historically disadvantaged communities, but the problem is not limited to underprivileged students at schools like DeVry or ITT Tech. After all, Columbia University is an Ivy League Institution (one of the oldest in the country) with an excellent academic reputation, outstanding (albeit highly priced) graduate programs and a substantial endowment to fund scholarships. (Note: most university endowment funds are restricted by the donors and can not be moved around between programs or purposes by the university administration.) And while the student loan problem at Columbia may be particularly acute in certain fields of study, as in the MFA programs, many MBA, JD and MD graduates at universities all over the country also find themselves overwhelmed with student loan debt and working in jobs that pay them much less than they thought they would earn when they enrolled in grad school.
Graduate students account for only 25% of the total number of student loan borrowers but half of the $1.5 trillion of outstanding student loan debt, much of it funded by federal loan programs like PLUS. You will recall that the median outstanding debt among Columbia MFA grads was $181,000 and some of the students profiled owed twice that amount. Among all US student loan borrowers, however, only 6% have more than $100,000 of debt outstanding and only 2% have debt of more than $200,000. Close to 20% of all borrowers have less than $5,000 of student loan debt, which accounts for only 1% of the total amount outstanding. If you wish to learn more about the demographics of US student loan debt, read this study from Brookings.
The WSJ article cited above raises many interesting questions of public policy, which I don’t propose to address here. But let’s at least identify some of these questions and perhaps we can come back to them in a later post. What exactly is the rationale for public (government funded and/or subsidized) student loan programs? How does this rationale compare for loan programs available to students at community colleges, private trade schools, public and private 4-year universities and graduate programs? Is the public funding rationale equally applicable to students pursuing courses of study in the liberal arts, STEM and professional programs? To students pursuing high and low paying jobs, in the private and/or public sectors? What should be the role of demonstrated financial need, or conversely borrowers’ credit scores, in extending or subsidizing student loans? Should student loan debt be more easily dischargeable in personal bankruptcy proceedings? What are the arguments pro and con for forgiving some or all of the currently outstanding student loan debt? How exactly would this sort of loan forgiveness program work? And what are the equities involved in forgiving current student loan debts but not extending comparable aid to past and future student loan recipients and to those who did not borrow to fund their educations? Student loan debt forgiveness is a hot topic in Washington right now and you can read about it here.
Rather than jump into this fevered public debate over student loan programs and debt forgiveness, what I would propose to do instead is to review the basic financial rationale for attending grad school in the hopes that this will be useful to those of you who might go back to grad school at some point in the future. I will also make a few comments that might be helpful to those of you who find now or later that you have taken on more student loan debt than you can comfortably manage. Excessive student loan debt is a problem for millions of Americans, so if you find yourself in this position please know that you are not alone.
Why go to grad school? There are of course many good non-financial reasons to attend graduate school and to pursue careers with high educational requirements but low financial payoffs. Say you want to teach English at the university level, become a public interest lawyer, or an ordained minister? These are all worthwhile pursuits that require advanced degrees but that pay very poorly. The returns one gets from these careers will be largely non-monetary, which does not mean they are insignificant. In fact one may get a tremendous amount of personal satisfaction out of these jobs, which may also have high social value. But graduates in these careers will likely find it hard to pay their bills from time to time, especially if they have taken on significant amounts of student loan debt. (This may also be true of higher earners, whose spending often grows to match or exceed their incomes.)
But for many students, the rationale for going to graduate school is largely or entirely financially motivated. By getting your MBA, you will progress in your career faster and earn substantially more money over time than had you not gone back to get your graduate degree. Or that is the hope anyway, and until recently it has been a reasonable one at least at the top MBA programs. Unfortunately this may no longer be the case today, or not to the same extent as in past decades. Read here to learn more about the situation at top MBA programs. Law and medical students face similar issues, with employment opportunities and compensation having failed to keep up with the rapidly rising cost of graduate school. But how should students go about making the financial decision to invest in grad school? What information do they need and how do they make the necessary calculations?
We measure the financial return from an investment in graduate education primarily in terms of incremental after-tax earnings. Let’s assume that the total cost of a full-time MBA is $250,000 (tuition, fees and foregone income for 18 months) and that a reasonable working life post-MBA is 40 years. If one expects to earn $40-50,000 of incremental pre-tax income immediately after graduation, that translates into around $25,000 of incremental after-tax income (depending on applicable tax rates). If that incremental income is growing at just 2% a year, the MBA is arguably worth somewhat more what you paid for it, perhaps $300k or so. But if your incremental income is growing at 5% per annum, the degree may be worth almost twice what you paid for it, or $500k. And of course if your initial incremental income is much higher than $25k, and/or growing at a rate higher than 5%, then that MBA degree which cost you $250k could well turn out to be worth $1mm or more. (To calculate these numbers, and simplify the math, I’ve used the Gordon Growth Model to approximate the value of the future income streams growing at a constant rate in perpetuity (which is not much different than 40 years in PV terms). I have assumed a somewhat arbitrary (arguably high) 10% after-tax unlevered discount rate to bring the numbers back to a risk-adjusted present value.)
You may have noticed that my analysis so far makes no assumptions about the amount or cost of borrowing for the proposed investment. This is intentional, for reasons you would learn in your first-year MBA finance course. We generally evaluate capital investment projects on an unlevered basis, ie without regard to the financing employed. Yes we will also want to consider the financing alternatives and costs at some point in the analysis, but only after we have determined that the capital investment is financially a sound one (which involves forecasting future cash flows and discounting these cash flows back to present value at a risk-adjusted discount rate, as we have done above). The key assumptions in our MBA capital investment analysis are the up-front cost of the investment ($250k), the incremental cash flows resulting from the investment ($25k per annum after-tax, growing at x% per annum) and the time horizon of the investment (40 years, which approximates perpetuity).
But in the real world we also need to consider the financing alternatives, which may make or break the deal for many students. You may have built a very credible financial case for going back to grad school based on your expected incremental income, but if you can’t come up with $250k of cash (plus living expenses) then you won’t be able to pay for it. And even if you can borrow the full amount, the numbers won’t work if the rate of interest paid on your loans exceeds the IRR on the investment, or if the repayment schedule for your loans is so short that you cannot make (or refinance) the monthly payments. The annual payment obligation (principal plus interest) on a $250,000 student loan at a 5.75% interest rate (the average of federal subsidized and unsubsidized rates for grad students) is about $33,000 if paid over 10-years and about $21,000 if paid over 20-years. (The monthly and annual payments are less for the 20-year amortization, but the total interest payments over the life of the loan will be considerably more, about $92,000 or so.) Note that the annual payment amount in the 10-year amortization scenario ($33k) is higher than our assumed incremental after-tax income ($25k), but this is not true in the 20-year amortization case. Many graduates early in their careers will choose to defer student loan principal amortization and continue borrowing the deferred amounts at their student loan rate, freeing up scarce cash to use for other purposes.
Many people go back to grad school in programs that are not likely to generate the sorts of incremental incomes described above So how do they manage? Well, some of them don’t manage particularly well, as in the case of the Columbia MFA students profiled above. But others have found a way to finance their educations without hobbling themselves financially for life. They do this with some combination of family money (not available to all of us), grants (scholarships) and in some cases large forgivable loans. I know that some of the top US law schools have substantial amounts of money available for both scholarships and forgivable loans for students who pursue public service careers. (Here is a link to the program at NYU Law.) Not all schools have these programs, and the amounts available are not unlimited, but if you are interested you should check them out. There are also publicly funded loan forgiveness programs, but I understand that the federal program is notoriously difficult to navigate and has proven to be unreliable for many participants. Be careful if you chose to go down this path.)
What about all those Columbia MFA film students, and many others like them, who invested several hundred thousand dollars in their graduate educations only to find out that they can’t get jobs in their chosen field or that these jobs pay not much more than what they were earning before they went to grad school? What do they do now?
The answer obviously depends on individual circumstances, but a good first step would be to make sure you understand the terms of all your student loans (and other debt). Those of you with federal student loans might first like to check out the Federal Student Aid website. How much do you owe, to whom, at what rate, in what amounts, over what time frame? These sound like obvious questions to ask, but I am told that many otherwise responsible students graduate knowing very little about their student loans, even the amount of their monthly payments or when the first payment is due. You will also want to know if your parents are liable for any or all of your student loan debt, which makes the repayment problem theirs as well as yours. (The federal government has two types of graduate student loans, one made directly to students and one made to parents of students. And some private loans may require parental guarantees.) Not everyone can do this, but some of you may find that your parents or other family members are financially able to help you out, perhaps by extending you a personal loan on more favorable terms than your student loans.
If you do get into serious financial trouble, your next step may be to get some help from a qualified, trusted and reliable advisor. Your advisor will help you figure out what exactly is the source of your problem and what might be some potential fixes. Sometimes the biggest problem with student loans is primarily one of timing of repayment. Perhaps you can’t afford to repay your student loans over the next 10 years, but you can do it over 20 years or with a short-term deferral or an income-based repayment plan. These sorts of repayment modifications are often available, but may come at the cost of a higher interest bill (more years of interest paid and possibly at a higher rate). For an overview of federal student loan repayment plans, read here.
Sometimes the student loan repayment problem is made worse by other debt that you have incurred, especially high cost credit card debt. In this case the solution may be to find other lower cost refinancing alternatives, perhaps through some sort of debt consolidation, or even to stop paying your student loan debt temporarily and use the money saved to pay off those credit cards asap. The annual interest rate on credit card debt is often 15-20+%, which can quickly compound to astronomical levels. (This compound interest calculator will help you understand the difference in outcomes when unpaid debt compounds at an annual rate of say 15-20% (credit cards) vs 5% (student loans).
And perhaps the problem is not solely attributable to your loans but also to your spending, which has gotten out of line with your earnings and your overall financial position. This is particularly common among young people, but many of us older folks are just as guilty of undisciplined spending. To take a trivial example, one venti latte a day at Starbucks will set you back close to $2,000 a year (even without those expensive and high calorie flavors you might like to add). By comparison, the annual payment due on a $100,000 student loan with a 4% interest rate and a 20-year repayment schedule is about $7,300. Cutting out your daily latte will not solve your student loan problem overnight but it will free up an amount equal to 25% of your annual debt service obligation. From just one latte!
If all else fails, you can explore personal bankruptcy. This may be necessary if things get completely out of hand and you have exhausted all your other alternatives. But you should be aware that student loan debt is generally not dischargeable in bankruptcy proceedings, unlike other forms of debt. There are exceptions to this, but I understand that few borrowers qualify. You can read about this here.
I do not mean to minimize in any way the very real personal and social problems associated with excessive student loan debt, or to trivialize the personal sacrifices that may be needed to fix the problem. And I really do have sympathy for those Columbia film graduates and millions of others like them. But at some level we each need to take personal responsibility for our own spending and investment decisions, even when our decisions have been facilitated or encouraged by easy money (federal student loan programs) and enticing or even misleading marketing campaigns (of university programs) Not everyone can or should go to grad school, and for many of us the best financial decision we might take is the decision NOT to go to grad school. Or at least not to do so until we have fleshed out the financial economics and can afford to pay the bills.
But there may be hope for at least some of those Columbia MFA graduates struggling to pay their debts. Perhaps they can get together and make a wildly successful film about the student loan debt problem. It worked with sub-prime mortgages after all.