Making money investing student loans isn't entirely impossible
Hello, bright-eyed college student. Congratulations on pursuing higher education. Way to do it champ, that’s the American dream. You’ve got a bookshelf full of knowledge waiting for you and soon a piece of paper saying you’re ready to take on the world. But oh wait, what’s this? A letter in the mail, demanding money?
Perhaps there’s a way to make it rain on the loan officer’s face while still holding a profit in your bank account. Stories continue to circulate about those who have done it — some even to the tune of millions — by opting to invest extra loan balances into the stock market like a savvy white-collared yuppy.
The idea is you’ll earn enough profit to avoid moving back home and listening to your parents talk about a promising future while you search for jobs on Indeed. But, it’s not easy.
While naysayers wag their fingers, Barry N. (not his real name, for reasons we’ll get to later) threw his borrowed dollars on the table and walked away a little richer.
“I did a 5-year degree, and in the fifth year (in Canada) your parents are no longer considered for determining your eligibility (on the basis of whether your income level is too high) for cheap, interest-free student loans,” says Barry. “So in the last year, I took out the free loan (about $10k), invested it into a broad index fund. I came out about 10 percent ahead, sold the investments, and paid off the loan just before it would start bearing interest (after I graduated).”
Barry managed to secure a loan with zero percent interest and was fortunate enough to sell just before the 2008 financial crisis. By the end of his education, his loan money had some sugar sprinkled on top. His is the Average Joe success story, but there are also superstars who have taken huge leaps toward becoming Scrooge McDuck by wisely investing their student loan money instead of buying college textbooks.
Venture capitalist Chris Sacca is known for sifting gold out of the startup community, having invested early in companies such as Uber and Twitter. But Sacca wasn’t always known for laughing at ideas on Shark Tank.
Back in the late ‘90s, he took out student loans for law school and instead of buying John Rawls’ “A Theory of Justice,” he invested in early tech companies. This was back between 1998 and 2000. And if you young’uns don’t know, under the majesty of Bill Clinton’s sexy saxophone, everyone thought technology would keep printing money until it could afford its own Ayn Rand paradise nation — no, really, all of Silicon Valley still has their copies of “Atlas Shrugged.”
Everyone thought capitalism had found its stride and things could only get better. So, Sacca took the money he borrowed and made $12 million by 2000. But, as anyone familiar with casino strategies knows, when people are on a winning streak, they often keep slapping bills on the table until the cars, house and hot wife are all gone. Unfortunately for Sacca, the dot-com bubble burst and enthusiastic tech investors were left with empty vaults, including Sacca — who quickly ended up $4 million in debt. Not that it crippled him for life. The point is, even a guy whose third eye is open for finance was at the whim of market forces when it came to his student loan investment.
Although he studied law, what Sacca did might not have been entirely legal. Maybe that’s what law school is for: learning where the gray areas are, e.g. student loan investing. Before you take your money and run to the computer to throw it all into Berkshire Hathaway’s Class A stocks (not that you can afford even one share — fractions are okay) we have to know whether or not we’re breaking the law Madoff-style.
LET'S TAKE A LOOK AT THE FEDERAL GOVERNMENT'S MASTER PROMISSORY NOTE (MPN): the contract students sign when taking out the loan. Any clause that might mean trouble if we’re going to roll the dice is right there on page one.
I will use the money I receive from any loan made under this MPN only to pay for my authorized educational expenses for attendance at the school that determined I was eligible to receive the loan. I will immediately repay any loan money that cannot be attributed to educational expenses for attendance on at least a half-time basis at that school.
Technically, violating this little edict is equivalent to committing perjury, which is why Barry was hesitant to give us his real name. Perjury is a criminal act. The helpful website Investopedia phrases it as such.
“Students who spend their federal loan money on expenses unrelated to education may not be committing a crime, but they could face legal action from the Department of Education if their actions are discovered.” the site says. “In some cases, this may include repaying subsidized interest.”
But no one’s sitting outside the window in a trench-coat snapping pictures of your daily finances. At least, as far as the government is concerned, and the private sector doesn’t care so long as they get their dollar-dollar bills back. This is one of those legal gray areas, where the practice is frowned upon but no one’s going out of their way to enforce the rules. Hell, the IRS’s budget was just cut; they don’t care about you.
Go right on ahead and use your loan money to take a cruise to Alaska, make haunting mistakes in Thailand, or smoke yourself silly with the finest sinsemilla. Just don’t post “Thank you Department of Education for giving me a loan for school which I used to take this vacation. This Nom Yen is great with vodka!” on your Instagram. Best to keep your mouth shut, especially if you’re eyeing up Activision Blizzard’s Q4 earnings report.
Investing your student loan money is not explicitly legal, but you’re not likely to face prosecution or fines if you do so. Instead, you’ll face a worse punishment: losing all your money in the market and owing whoever lent you the loan a lot more. But let’s say we don’t care. We’re risk takers.
We turned to a few finance gurus willing to share information on Reddit — since experts aren’t too keen on attaching their name to legally questionable practices. They agreed there’s only one circumstance where you should be throwing your student loan money at the market.
“If you have the cash on hand to pay your college expenses outright, and you have amazing self-control, then it could potentially make financial sense to invest the loan money in the market if the interest is subsidized,” writes notthatkindadoctor. “Basically if it’s a zero percent loan and you get, say, around six percent return in the market, it might make sense to invest.”
That’s a pretty specific situation since zero percent interest loans are golden grails. It means hunting — filling out form after form, after form — to find an organization willing to bet on you. That organization will end up being a charity, and taking a loan from a charity and throwing that money at the market raises a layer of ethical turmoil. But, maybe the hopeful smiles of your beneficiaries don’t bother you. Good, because zero percent interest is the minimal risk you want, and you always want to minimize your risk when investing, unless you’re the kind of person who hangs out by the East River alley making Wall Street bets.
More realistically, you’re one of the millions of students with an impending interest rate somewhere between four percent and seven percent, and you don’t have the cash on hand to pay for college. In that case, it’s not a wise idea to invest your student loan in the market. But when has gambling ever been wise?
With the facts in order, should you be investing your student loan?
“No. And even in saying no, I know that people will want to prove me wrong, but it’s an incredibly risky strategy with very little realistic upside for amateur investors,” Pete Dunn (a.k.a. Pete the Planner) tells us. He’s a USA TODAY columnist who regularly broadcasts his financial wizardry on CNN, Fox News and his own radio show, The Pete the Planner Show on 93 WIBC FM. “It would be a terrible idea even for expert investors because of the short time horizon.”
Essentially, the odds of you keeping pace with the market and beating the looming interest rate on your loans is near zilch, though not impossible, as Barry and others have proven. But you better find religion if a recession hits — à la 2008 when the S&P total return was negative 37 percent. Markets shift and a long ride on the bull can make it seem more promising than it actually is. Stocks are volatile: they go up, they go down, they turn around and disappear from existence.
Pete adds, “This route is absolutely a gamble. You would need at the bare minimum to let the market sort itself out. Also, we are in the midst of one of the longest bull markets in history, which is to suggest in the short-term we are due a bear market.”
WE ALSO SPOKE WITH CERTIFIED FINANCIAL PLANNER JON LUSKIN and asked him to entertain a hypothetical: if we have student debt with an interest rate of four percent, can we beat the market in time to paint our cap and gown with gold?
“Maybe. Maybe not,” he replied. “It depends upon what you’re invested in. It certainly depends on your time horizon. In the short term can you earn more than four percent? It’s hard to say. If you’re investing for the long haul, i.e. 30 years, then historically if you’re looking at what the market has done — not to say what it’s going to do going forward — you’re going to see returns well in excess of four percent.”
As Jon Luskin writes in “Four Simple Rules of Investing,” the key to success is to keep your costs low, diversify, buy & hold, and pick the investments that are right for your risk tolerance. Investing that way is boring, but historically the odds are in your favor.
But what if we still want to invest? Despite the odds, we’re happy go-lucky students who have a premonition of striking the right spot in the earth and hitting a money well. First, you should probably do your research (or, “due diligence”). There are plenty of distilled Nobel prize-winning strategies that guide smart investments, such as The Boglehead investment philosophy, which leverages Eugene Fama’s efficient markets hypothesis. Have no idea what those are? Hit the books before hitting the market.
Overall, the safest possible setup, according to experts, goes a little something like this:
If you have enough money to pay for college and you’re offered a subsidized loan then by all means, invest in every odd-sounding pharmaceutical brand that pops up (though watch out for anything connected to the ever-punchable Martin Shkreli). But don’t use the loan money. Use that cash on hand to invest, and use the loan to pay for school. Then, once the loan letters taint your mailbox, use the invested money to pay it off. Hopefully, the market stayed strong and you didn’t lose everything due to a routine recession.
Pro-tip: make sure you choose an index fund. Don’t dare try and pick stocks yourself unless you’ve been in the game since you were 13. Index funds are a broad, passive investment that match the average return of the market. They’re also cheap to throw money at thanks to low-cost management fees.
The most popular index funds track the S&P 500. But there are other index funds to choose from, and plenty of them. Money is spread out to maximize a return, and minimize risk, while keeping pace with the stock market.
In general, the market will turn a profit if you wait long enough.
There’s a cliché in the investing community that “the stock market has averaged 12 percent over its history.” Maybe it’s that phrasing that makes some students risk their loans in the Wild West. However, it’s not exactly true. Not even close. The market oscillates between mania and depression rather than being consistent, with years of growth and years of struggles.
“So in a nutshell, you would be fortunate to average around seven to eight percent rate of return on a long-term basis,” adds Pete the Planner. “There will be periods in which you get a 20 percent rate of return. These are the great times. But there will also be times in which you are getting a negative 15 percent rate of return.
“The five year average for the S&P 500 from 1995-1999 was 28.56 percent. That is just freaking ridiculous,” he continues. “Honestly. People tripled their money in just five years. But this is where the market can be a fickle beast. That ‘tripled’ initial investment from 1995 was reduced by negative nine percent, negative 11 percent, and negative 22 percent in the following three years (2000, 2001, 2002).”
And he’s talking long-term; we don’t have long-term before paying off everything borrowed. Unless you can guarantee a job upon graduation and keep the money in the market while using a guaranteed salary to pay back the loan — but you’re not likely to do so. Also taxes, don’t forget about taxes.
“After accounting for taxes, the nine percent investment return is now roughly seven percent,” writes Adam S. Minsky. “Given that, it would have made more sense to pay off his student loan balance than invest.”
You’re better off paying off loans immediately instead of investing that extra money, and waiting patiently for a stable job in which you can take 10 percent of your income to play capitalist simulator 2017. Rent’s bad enough. Debt is no joke.
However most things in life are a gamble. Play at your own risk.