Friday, October 9, 2015

Principal vs. Interest Payments on Borrowings ... Properly Educating Our Young Friends About 'Speculative' Student Loan Borrowing Is Lacking in America's 'New Normal' Combination of Low Inflation and a Slow Growth Economy

{NOTE: Our most recent post concerned the widespread ignorance surrounding student loans and the negative impact that indebtedness at a young age has on far too many lives. This one should be read as an important part of that continuing discussion.}

The plain fact associated with ignorance and borrowing is that how and when the principal amount to be repaid will in fact be repaid is often ignored by the borrower when taking out a loan.

Sellers today focus on the attractive low interest rates and borrowers don't focus on what it will take to repay the amount borrowed over time. This is speculative borrowing, pure and simple, and begins a dangerous practice for first time borrowers which likely will become an established habit later for borrowing on credit cards, home mortgages and auto loans. At that point the hole is deep and the outlook for one's financial security is worrisome at best and disastrous at worst.

To add to the problem, this now well established practice of ignoring the requirement of principal repayment at the time the loan is made is especially troublesome in a non-inflationary economy --- such as the one we have now. When inflation reigns, principal can be repaid in cheaper dollars. Of course, the reverse happens when inflation is low, as it is now and will be for the foreseeable future as well.

Nevertheless, we are encouraged to borrow that which we may very well be unable to repay, even though those doing the encouraging know better. After all, the 'encouragers' are usually the educators and the government providers of the money we've borrowed and which is then pocketed by the educators. This collusion between the educators and government lenders does a great deal of long lasting and often irreversible financial harm --- and is harm from which many borrowers will never fully recover.

With that background, Colleges, Uncle Sam, owe student loan borrowers an education says this in pertinent part:

"The media is filled with stories about student loan debt. . . . They focus on the nearly $1.2 trillion in outstanding student loan debt, an amount that exceeds auto loan and credit card debt.

We are told that nearly 70% of four-year college students graduate with student debt that averages about $30,000, and some owe more than $100,000.

The student-loan burden apparently is even reducing the number of first-time home and auto buyers, delaying marriages and retirement savings and reducing the number of children being born. And the net worth of young households with student loans is substantially lower than those without student loans.

What is often missing in these portrayals of student debt is an explanation of what the federal government and colleges are doing to give student loan debtors the personal finance knowledge and skills that they need to safely and responsibly manage their debt.

Federal law requires colleges to provide student loan counseling to first-time borrowers. After this single educational intervention, often at the stressful beginning of college, the next time students might talk about finances is during the exit interview, when they are graduating (or leaving the college). Student feedback indicates that most do not comprehend the information provided in these sessions and view the information as one more requirement of the financial aid process rather than a learning opportunity. . . .

Except for the few elite colleges with huge endowments, most of the two- and four-year colleges could not exist without student-loan funding. Professors and administrators ultimately rely on these loans for their take home salaries and benefits. In 2014 approximately $134 billion in federal student loan debt and grants was used by colleges for expenses, an amount roughly equivalent to more than seven times the 2014 total operating expenses of Apple Inc., the largest company by market capitalization in the S&P 500. . . .

And yet, the vast majority of colleges are not providing students with substantive and mandatory personal finance instruction, especially as it relates to how they should manage the economic burden that they are taking on to get a college degree.

Higher education has a moral obligation to help the students understand how credit and credit scores work. Students should learn from trained individuals and the efficacy of the program should be measured.

We know that college students often have not received personal finance training in grades K-12 or at home. So, as colleges load young people with debt, they also must give them the tools that they need to responsibly manage it. . . .

For most students, their first experience with debt is their student loan, and they simply don’t understand the consequences of this transaction, even as they take on additional loans to complete college. . . .

In 2008, the President’s Advisory Committee on Financial Literacy recommended that the president direct the departments of treasury and education to require college students to take a much more comprehensive course in financial literacy than is currently required. Sadly, this recommendation was never acted on. . . ."

Summing Up

An already bad situation is rapidly deteriorating as the old high inflationary economy transitions to the 'new normal' low inflationary economic environment. The absence of inflation isn't all god news and represents bad news for borrowers with heavy indebtedness.

Because when inflation is quiescent, nominal wage increases are small but real, nominal interest rates are low but real interest rates are high, and the repayment of principal becomes more difficult and expensive as the dollars previously borrowed are the equivalent purchasing dollars that must be repaid.

Here's the real deal --- the interest rate on borrowings isn't even close to the most important element in a long term loan. Instead what matters most is the principal amount which has to be repaid ---  as well as where the additional money will come from to pay back that principal amount borrowed.

Thus, how we will manage to earn enough additional income to repay the new borrowings, plus interest, is of the utmost importance. Because the lack of stable and high paying jobs, high single digit salary increases, and inflationary home prices won't bail us out in this new and ongoing non-inflationary and sluggish economic environment.

That means simply that the routine speculative borrowing which has become the norm with respect to paying for expensive college costs has become a most tricky, risky and often mindless endeavor.

Yet if not appropriately forewarned and therefore forearmed with relevant information, our young students, future home owners and nation's leaders won't know what they don't know until the debt hole is deep and it's too late to do anything about it.

Financial literacy is sorely lacking in our schools and too often in our homes as well.

That's not a healthy sign for the future financial health of today's young Americans.

That's my take.

Thanks. Bob.

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