Monday, August 10, 2015

This is news somehow?

I've come across a few articles recently that I really hope aren't actually news to anyone reading them.
The basic theme of the articles is that you may find it harder to qualify for a mortgage if you have a lot of student loans. Really? That's supposed to be news? Just because your debt is a student loan doesn't mean it all of the sudden isn't debt. Just like you'd have a hard time buying a house if you already spent half your income on car payments, if a large portion of your income is used to cover payments on student loans, banks will be hesitant to loan you even more money for a house.
One of the authors went so far as to say you may be better off not even going to college since you can still make a decent income without a college degree and you wouldn't be saddled with mountains of student loans.

Taking a step back, I decided I wanted to look at this problem through a finance lens. In finance, when evaluating between two decisions, an easy analysis can be done called NPV, or Net Present Value. The purpose of the analysis is to compare two alternatives, and to account for the fact that having some money today is better than having the same amount of money in the future. In this case though, the question is whether going to college is worth the extra time and energy required versus just finding a job right out of high school and skipping college.

U.S. News reported that, on average, a 25-32 year old with a college degree earns about $17,500 per year more than their peers who only have a high school diploma and the average starting salary for a college graduate is around $45,500. Assuming that each person's income grows at 3%, you would actually expect that gap to widen over time. Looking at those numbers, it's no wonder that most people agree that getting a college education is worth the investment. Even foregoing four years of income in order to study you can expect to earn upwards of one million dollars more over the course of your lifetime just for having a college degree. But what about those four years of school where you aren't earning any income? That's where this handy little NPV analysis comes in. This allows us to judge between two decisions by discounting the income from future periods to a 'present value'. Here's what I came up with:

A few things stood out to me from this chart. First, how crazy is it that a college graduate could earn about $1.5M more over the course of their lifetime?

Now, when comparing alternatives with NPV analysis, a higher NPV is better. As you can see, going to college without incurring any debt is your best long term strategy. The way I think about it though, whether to go to college is not a $1.5M decision, but rather a $80,000 decision (the difference between NPVs, not the difference between lifetime incomes). This is because even though (on average), you can make more income, a lot of the extra income is later in life and so not as valuable as income today.

Lastly, it is worth noting that this analysis shows that a getting a degree with some debt is still better than not going to college at all. The average student that graduates with debt has about $28,000 in debt. What these numbers show us is that, while still a higher NPV, by taking on debt to fund education, you effectively give up 20% of the benefit of the increased income.

I'll be honest, when I first read that the average loan balance of college graduates was $28,000, I was surprised that it was so low. Financial news sites seem to only highlight cases where people borrow $100k+ and get a degree in a low paying field and then use these extreme examples to show that college isn't worth the investment. What's sad is that this same analysis shows that they are probably right. If you do happen to borrow $100k to get a degree that can only help you get an average paying job, this analysis would show that the act of borrowing heavily to finance an education negates the majority of the additional earning potential.

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