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Thursday, October 26, 2006

Two disparate stories

Two disparate stories in today's news concerning the value of a college degree and the amount of debt students incur to earn a degree.

This story suggests that students are taking on intolerable levels of debt to pay for college:
He graduated from the California Culinary Academy in San Francisco in 2005, but he said his subsequent low-paying job as a cook has made it nearly impossible for him to repay the $35,000 he borrowed.
Okay, that might not be a good example of a well invested college education as the person involved is earning $1,200 per month (?!)

This 2002 story suggests that the average student debt load at the time was considerably less than $35,000:
In 1999-2000, 64 percent of college students graduated with student loan debt, and the average debt has nearly doubled during the last eight years to $16,928, according to a report from the State Public Interest Research Group's Higher Education Project.
Let's say the debt had increased by 50% to about $25,000. Is this still a bad investment? Is there a national crisis at hand?

The second of today's disparate stories suggest that such a debt load is not a bad investment:
How much is a bachelor's degree worth? About $23,000 a year, the government said in a report released Thursday.
If true, this suggests that taking on six to eight thousand dollars per year will return $23,000 a year for, let's say, the next 40 years. If we assume an annual salary growth rate of a three percent annual and a discount rate of 4 percent, the 35 year real value of the increased salary is $686,000. In other words, for $25,000 in debt for college the lifetime payoff is $686,000. Most rational people would look at this trade-off as reasonable.

While some people might take on more debt and may not earn as much after their degree, on average taking on the average amount of debt for an average college degree that yields an average increase in salary doesn't strike me as a crisis. A crisis would be if the amount of debt and it's service outweighed the expected gain from a college education. At an interest rate of 10% and a twenty year payoff schedule, the total amount spent on the $25,000 is approximately $58,000.

Here is where I think there is a bit of a disconnect when it comes to college debt. First, I wonder how well students understand the value of the degree they seek to attain. An English degree is relatively easy but is also relatively less valuable than, say, an economics degree. Moreover, if students are used to driving a three year old BMW that mom and dad provided during college but have little understanding about how much it costs to own a BMW and how long one had to work to reach a point where the BMW was even remotely affordable, this lack of information can be costly.

If our new English major (or culinary institute major) gets an entry level job and purchases a new BMW, it is likely that they will be consuming beyond their financial means. They might find themselves facing financial stress but not because they took on too much debt for college but because they took on too much debt for consumption.

The solution isn't to tell mom and dad not to provide the BMW, nor to bail students out of their well-invested debt, after all the payoff is substantial. Rather, more information about the costs of living and the average lifetime earnings profile might elevate some of the problems being reported in the media.

For the most part, high consumption levels are not practical (nor potentially desirable) early one's career. If instead of buying a BMW, one bought a Focus and applied the difference in payments to college loans and an IRA, in a few years one could afford multiple BMWs.

[Follow up: After class I thought, "what discount rate would be needed so that the $25,000 in college loans would not be a `good deal'?" I recalculated my spreadsheet and, I think I am right, a discount factor of 0.73 will do the trick, assuming a three percent annual growth rate in wages. A discount factor of 73% is HUGE when most other estimates are lower than 20%. While a discount rate of 73% is not impossible, in my mind it would imply a level of impatience that is unhealthy. Perhaps college graduates are that impatient for the conspicuous consumption?]

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