Ask (and Answer) the Right Questions Before Taking Out Student Loans

When you could pay your way through college by waiting tables, the idea that you should “study what interests you” was more viable than it is today, when the cost of a four-year degree often runs to six figures.  For an 18-year-old, investing such a sum in an education without payoff makes no more sense than buying a Ferrari on credit.  –Glenn Harlan Reynolds, law professor at the University of Tennessee, from an article in the Wall Street Journal (January 3, 2014) entitled “Degrees of Value: Making College Pay Off”

There is a cartoon I like by Walt Handelsman.  The first panel shows a proud father talking to his cap-n-gown wearing son who has just graduated from college.  The caption says, “…At the rate I am going, my student loans should be paid off in 3 years…”  The second panel has the son replying, “That’s great, dad…”

Here is a link to another student loan cartoon, this one by Lisa Benson, that humorously depicts how students feel when they leave college loaded down with debt.

Student Loan Statistics

So how big a problem is student loan debt in America?  The Huffington Post reports some interesting statistics:

  • Outstanding student loan debt in the United States currently totals $1.1 trillion dollars
  • Student loan debt has nearly tripled over the past 8 years 
  • More money is owed for student loans than for any other kind of debt except home mortgages
  • The average amount of student loan debt for the graduating class of 2011 was nearly $27,000  
  • More than 1 in 10 borrowers defaulted on their student loans in the three years leading up to September 30, 2011

It is clear that student loan debt is a large and growing problem, and that many people have taken out loans they cannot afford to pay off.   

Make Sure There is a Payoff

So how can you avoid becoming the father in the cartoon?  The key lies in the quote I started off with.  You simply shouldn’t take out student loans unless there is a high probability of a financial payoff for doing so. 

I believe education is worthwhile apart from its financial benefits.  Studying what interests you is often good advice but when you have to take out loans for school the entire equation changes.  You will have to pay the loans off some day and your financial life should be easier after graduation than before.  The time to figure out if student loans make financial sense is before taking them out and it will require some careful analysis.

How Our Brains Work

In his book Thinking, Fast and Slow, Daniel Kahneman, winner of the Nobel Prize in economics, gives a simplified description of how our brains work.  Kahneman explains that our brains consist of two systems, which he calls System 1 and System 2. 

System 1 is our intuitive, fast-thinking, subconscious brain.  It is always on alert monitoring things and helping us to decide how to respond.  It is not capable of performing calculations or thinking deeply.  One of its functions is to be a filter, deciding what gets passed on to System 2.

System 2 is our logical, analytic, thinking brain.  It usually stays in the background letting System 1 do its thing.  It is capable of great things when motivated, but it is basically lazy and does as little as necessary.       

When we face a question System 1 takes the first stab at it.  System 1 can only answer very easy questions but it doesn’t like to admit defeat.  It would rather answer a question than hand it off to System 2. 

To get around this problem System 1 likes to play the “Substitution” game.  If it is asked a question it can’t answer it will instead respond to an easier related question and pretend it has answered the real question.  System 2 can call out System 1 on this trick if it wishes, but that would require a lot of effort to answer the question itself, so it often doesn’t.  

Student Loans and the Two Systems

When it comes to student loans we should ask ourselves a question like, “Should I take out student loans to get x degree from x university?”  This is a difficult problem that will require research, computation, and deep thinking.  To answer this question, at a minimum, you need to consider:

  • How much will the degree cost me?
  • How much of the cost will I have to borrow?
  • What will my interest rate be?
  • What is the job outlook in the field I am studying?
  • What can I reasonably expect to make upon graduation?
  • What am I making now, or what could I make now if I forgo school and work full-time?
  • What is the difference between what I am making now and what I can make upon graduation?
  • What is my break-even point in years? In other words, how long will it take me after graduation to make in additional income the amount I will have to pay back in principal and interest?

When System 1 gets this question it realizes immediately it can’t answer it, and like a talented politician it skillfully substitutes a related question that it can answer.  System 1 might replace the real question with one like “Would it be good for me to get more education?”  It quickly provides the obvious answer of “yes” and tells System 2 it has everything taken care of. 

At this point you have a decision to make.  Do you go along with the deception of System 1 or do you make the effort to engage System 2 and determine if your education plan makes financial sense?  To avoid purchasing the “educational Ferrari” referenced by Professor Reynolds earlier the answer is obvious.  You have to put System 1 in its place and perform a careful analysis before going into debt for education. 

Next time we will discuss how to perform the payoff analysis and what to do if your first plan doesn’t make financial sense.              

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