Saddled by Student Loans

Recent college graduates' struggles to pay back massive student loan debt has been in the headlines a lot lately. It's a real problem for our economy and our country, with very real consequences, including stalled lives as young borrowers struggle to pay back tens of thousands of dollars to multiple loan servicers. Seventy percent of today's college students have school debt, and the average they owe is $28,400. The total amount of U.S. student debt is $1.2 trillion.³ Some believe this will trigger the next financial crisis, and it's certainly never good to have a big group of potential consumers enter the marketplace with unattractive debt-to-asset ratios that hold them back from buying and borrowing.

High student debt burdens affect your ability to buy a house or take on any other debt, according to the Federal Reserve Bank of New York.⁴ These debts may cause you to put off settling down and buying a home. Only one-third of millennials head their own households, Pew Center for Research found, a nearly 40-year low.⁵ Thirty-six percent of millennials—21.6 million young Americans—live in their parents' homes. The trend is so pervasive that GQ wrote “A Millennial's Guide to Having Sex While Living at Home.”⁶

Young debtors have more depression, family dysfunction, higher suicide and divorce rates, and are less likely than nonborrowers to apply to graduate school (a move that would boost their lifetime earnings) than those without such debts. They contribute less to employer-sponsored retirement plans, losing early years of compounding and causing a lifetime wealth loss of more than four times the amount borrowed.⁷

We call student loans working debt because investing in a degree is well worth it—you will earn more and have an easier time finding a job than someone without a degree—but it can come with oppressive terms. Federal and private student loans are draconian to defaulters, who are handed over to private collection agencies that earn a percentage of recovered fees. After penalties and collection agency fees of up to 20 percent, a 10-year loan can nearly double in size.

The Federal Trade Commission received 181,000 complaints—more than any other industry—about abusive debt collection practices such as incessant phone calls, bullying, misrepresentation, and threats.⁸ If you default, collection agencies can garnish up to 15 percent of your paycheck and seize Social Security, disability income, and federal and state income tax refunds. You could lose state-issued professional licenses or public employment. Even if you declare bankruptcy, you'll remain liable for the original principal balance, all accrued interest, court costs, and collection fees—with no statute of limitations.

If you grew up in a middle-income or upper-middle-income family, you got caught in a rough deal. A “moderate” annual college budget today is $44,000 for private colleges and $22,000 for public universities, and your family probably didn't qualify for federal aid or loans (most middle- and upper-income families don't).⁹ You or your parents likely had to take out a higher-interest federal Parent PLUS loan or private amortized loans.

Loans are now the largest funding source for college education expenses and the second-largest liability on household balance sheets after mortgages—and families in higher income brackets are taking on student loans faster than any other demographic, according to a Federal Reserve report.¹⁰ Most parents have great intentions of paying for their kids' education, but when it comes down to it, meeting skyrocketing tuition costs with stagnating wages hasn't been easy for anyone. The typical family can cover just 30 percent of college expenses, the Lawlor Group found.¹¹

A lot of families turn to private student loans, with variable and fixed rates as high as 13 percent. These come from multiple vendors with a tangle of terms, conditions, and repayment schedules that many people find confusing. A Consumer Financial Protection Bureau survey about debtors' experiences with private student lenders found that borrowers had difficulty deciphering why payment amounts change, negotiating alternate payment plans, and dealing with lost payments. Unlike the federal government, most private lenders don't allow deferments or income-contingent repayment plans, and loans may go into default after one missed payment.¹² Oftentimes there's no way to strike that black mark from your record.

Facing the possibility of student debt, credit card debt, a low savings rate, and the desire to do fun stuff, what are things that millennials can consider? The following suggestions are designed to help buck this trend.

The Best Budget: Spend Less Than You Make

Many, if not most, of the financially responsible people I know have the following in common:

1. They know how much they make. If they are on a commission or bonus system, they use a very low number for their planned monthly earnings, often directing all of their bonuses to savings.
2. They save first. Generally, they save at the higher end of my suggested ranges: between 15 and 25 percent of their income.
3. They save automatically. This happens in a few ways:
   1. Money automatically comes out of their paycheck and into their 401(k) or other employer-sponsored plan, before it even hits their checking account.
   2. That money automatically gets matched over time by their employer.
   3. They automatically move money each month out of checking and to their investment or savings accounts.
4. They do not carry balances on credit cards—ever. As a result, they wait to buy things until they have saved up for them.
5. They hold at least a three-month (and generally six-month) reserve in their checking account. They would never let it get anywhere near zero.
6. They generally do not want things and live life more simply than many of the people around them.

From here, I find two different personality traits to those that are financially on track: the bloodhound and the ostrich.

1. The Bloodhound

   Bloodhounds track every expenditure every month across every account. They bark loudly when anything is off track or they find an error. One of the greatest benefits of the bloodhound is that they are on top of things; they know what is happening in all of their accounts at all times.

   One of the most formidable challenges is that while they can be great savers—and perhaps because they are great savers—often they are not great investors. You cannot, and should not, track your long-term investments the same way you track your checking account. Portfolios go up and down. Too often, bloodhounds react in the down cycle and change their philosophy. Because they track things so closely, the bloodhound can have a tendency to buy high and sell low.

2. The Ostrich

   It turns out that it isn't true that ostriches bury their head in the sand to avoid danger. The ostrich has amazing fight-or-flight capabilities. They are the fastest birds on land (and one of the faster animals overall) and they have the ability to fight—and even kill—lions.¹³ The ostrich is a symbol of simplicity, to enjoy the little things and to uncomplicate our lives. While bloodhounds track everything, the ostrich wants for little, looks around at other birds flying and doesn't care. They prefer being grounded. Economically, they don't track their finances daily because they simply live within their means. Money is not the center of their life and they have little concern for it because they regularly save and regularly spend less than they make.

   One of the greatest advantages is their ability to be excellent long-term investors and to shrug off short-term market movements. One of their greatest challenges is that they could tend to oversimplify complex issues that could require a little more attention.

Debt-to-Income Ratios

Throughout the book I recommend more conservative debt ratios than most banks use when determining how much you can borrow. Maxing out what banks are willing to give you is a very risky path. Throughout my life I have made probably 50 spreadsheets looking at expensive toys that I wanted to buy or investments that could “make me rich.” My results were always the same. If I had to make a spreadsheet, I couldn't afford these things. I wish I could have all that time I spent building spreadsheets back.

Our culture focuses on debt-to-income ratios because they make it possible for people—especially young people—to buy things like houses and cars that they could otherwise not afford. Focusing on debt-to-asset ratios makes it very difficult to buy these things, especially when you're young. For example, if you wanted to buy a house, you would have to have saved more money than the value of the house you want to purchase. This is an unrealistic proposition for most people.

Points to consider about debt-to-income ratios:

1. The goal is not to borrow as much as the bank will let you borrow. How much the bank is willing to lend you should have nothing to do with how much you wish to borrow.
2. Do not count on raises or higher future income. When we make assumptions on future income that do not materialize, we become sad, frustrated, and mad. Those feelings manifest at work and at home.
3. If you're worried whether or not you can afford something, then you have your answer: you cannot. There are lots of things in life you can't afford. Get over it.
4. If you have to use a calculator, make a spreadsheet, or do any detailed math when looking at a purchase, you definitely can't afford it.
5. Pay cuts happen. When using income to buy things, assume a 10-percent pay cut and no raises.
6. Saving is mandatory—unless you like the idea of eating cat food when you're old or depending on the government or your kids to take care of you. Therefore, savings is not a part of income that can be used for the calculation. If you make more than $50,000, you should be able to save 20 percent of your income.

Always assume that you will be unemployed for at least three to six months at some point in your career.

If your income is commission-based, assume a 30-percent lower income. Commission is fabulous, but the most successful and happiest people I know who have had long careers in commission-based industries have lived well within their means. I think this is why they had such wonderful careers. Those who became dependent on high incomes blew themselves up.

To pull this all together, take your current income minus a 10-percent pay cut assumption, minus 20-percent savings, and that's the income you can use for debt-to-income ratios. This equals a 28-percent reduction in your income. Remember to be more conservative if you work on commission.

The Consumer Financial Protection Bureau states that debt-to-income ratio is “one way lenders measure your ability to manage the payments you make every month to repay the money you have borrowed.” It is calculated by adding up monthly debt payments and dividing them by gross monthly income (before taxes and deductions). The Bureau found that mortgage loan studies suggest that borrowers with higher debt-to-income ratios run into more trouble making payments. A 43 percent debt-to-income ratio is the highest you can have to get a mortgage,¹⁶ and Bankrate encourages people to keep it under 36 percent.¹⁷ I recommend keeping it under 33 percent and ideally at 25 percent.

Pulling These Concepts Together

Here are ideas to pull it all together:

1. Spend less than you make.
2. Save off the top—and set a ramp to the 15 percent to 20 percent number.
3. If your net worth is less than 50 percent of your annual income, do not take on new debt, of any type.
4. Pay off your oppressive debt as quickly as possible.
5. Strive for a perfect credit score.
6. 36 percent of millennials are living at home: if you can't beat them, join them. If you save $750 a month in rent for 48 months, you just put yourself $36,000 ahead!

Combine these ideas with the material about the Launch phase in Chapter 3, and the rest of your life will be different because you will have broken the paycheck-to-paycheck cycle.¹⁸