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If I have money in various mutual funds / 529s / other college savings plans, would it be wise to take out interest-free loans for the duration of my education (in order to allow the money saved to continue generating interest, and also to work on a credit score) and pay the loans off with the money immediately after they start generating interest, or should I simply use the money I have saved directly?

I am an undergraduate student soon graduating high school.

curious-collegiate-314
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    Note that student loans are not a qualified expense for a 529. – user48207 Apr 04 '17 at 14:00
  • If you can afford to pay for something with cash, why would you take out a loan? I can't think of a single reason in any scenario. – user428517 Apr 05 '17 at 00:00
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    @sgroves: The loan is free and the cash accrues interest. – Mooing Duck Apr 05 '17 at 00:15
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    @sgroves: I can't think of a single not to do this actually, at least beside it being lots of paperwork (or unless you lack self-control on what you spend)... – user541686 Apr 05 '17 at 06:04
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    Having cash is useful. It means that you may not have to take out a loan for something else later. For example: I have cheap and safe (non-us) student debt, which I could pay off early. But I won't, because I'd rather have debt and a house deposit. I don't know enough about US debt to answer this question though. – Nathan Apr 05 '17 at 10:09
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    @sgroves The loan is not free. At best, the interest is subsidized while you are in school. As soon as you graduate, you start accruing interest. Now if you've been conservative and kept the cash aside (not the 529s, as explained below), then you might come out ahead. Or you might decide "I need a car" and keep the loans around a bit. Or you might think "I could buy a house, and the student loan will be cheaper". The next thing you know the loans are still around and you don't have the cash to pay them off. That's what I did so I know it can happen. – D Stanley Apr 05 '17 at 13:22
  • sgroves sorry, the comment above was a reply to @MooingDuck, not you. – D Stanley Apr 05 '17 at 15:31
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    @DStanley If you had not taken the student loan and bought house with mortgage later, you'd end up in exactly same place. Your loan-fueled spending was the problem, not the loan itself. And the loan is free. Precisely because other people are paying the cost, it's free to you. Anyway, while opposing your method, I agree with your conclusion to spend 529 directly. Because I don't see how taking 10% hit (or even risking it) in exchange for 0% loan makes this even a question. – Agent_L Apr 05 '17 at 15:36
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    @Agent_L No, I'm saying there's temptation to use the cash you saved and use it to buy (or put a down payment on) a house, thereby extending the life of the student loan(s). – D Stanley Apr 05 '17 at 15:39
  • @DStanley The temptation is always there. You can get a consumption loan or car financing plan anytime. It's part of growing up to learn to resist it. – Agent_L Apr 05 '17 at 15:45
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    @Agent_L: While I agree with your point, I disagree with your language. It's a very difficult thing for almost anyone. Mathematically, it's better to keep the money in mutual funds. Psychologically, it's very difficult for most people. Same with advice for which loan to pay first. Mathematically: the biggest interest rate. Psychologically: paying off the smallest first ends with better results 99% of the time. https://money.stackexchange.com/questions/48073/why-would-anyone-want-to-pay-off-their-debts-in-a-way-other-than-highest-intere/48085 – Mooing Duck Apr 05 '17 at 16:41
  • @MooingDuck I get it, but that line of answer seems more suitable to psychology. or personaldevelopment. stackexchange. And I also don't think it's very difficult for almost everyone. There are people who can control themselves easily and those who struggle to do it. It's the latter who fall into trouble more often and ask for advice more often but it doesn't mean that such situations objectively happen more. IMHO once you stop dealing with cash and just balance out the numbers (like accountants do), the psychological difference vanishes as well. – Agent_L Apr 05 '17 at 17:00
  • @MooingDuck and fighting loans is effort completely misplaced. It's the spending that's the problem, not loan which is merely a tool to sustain the problem. Don't tell people to stay away from knives, teach them to use knives properly. – Agent_L Apr 05 '17 at 17:02

5 Answers5

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Here are the risks involved with student loans:

  • They are very difficult to get discharged in a bankruptcy - the only way you can get rid of them is through death or disability (there are forgiveness programs but they are designed for people that can't pay them back, which means you shouldn't have taken a loan in the first place)
  • They encourage you to spend more - if you aren't paying anything until you graduate, then it "feels like" free money - you aren't encouraged to reduce costs. You might buy new books, take more classes, new school clothes, buy more expensive meal plans, etc. If you're paying cash you "feel the pain" of costs and are encouraged to reduce them (or get a part-time job to generate some income). Or worst-case - you go to a college that you can't afford. There are studies that show that, all else being equal, the college you attend does not significantly affect your salary. Your abilities, work ethic, and career choice are much more significant.
  • There's no "asset" to return to satisfy the debt - unlike a car loan or a mortgage where you can turn i the asset to satisfy most (or all) of the debt.

So - what happens if you decide (or are forced) not to finish school (50% of students don't)? You have no degree to boost income, but still have the debt.

What happens when you graduate and want to use that saved cash buy a house, car, etc., and treat the student loans as a monthly bill? The next thing you know you're loan-poor and are struggling to make your monthly payments just like most other "normal" people.

You aren't going to earn significant interest on your cash while you're in college (and it will not outpace inflation), and there's significant risk of your college savings losing money if they're not in risk-free investments, so it would NOT be wise to take out student loans when you have the means to cash-flow it.

Also, student loans generally charge a roughly 1% fee, so that actually negates the interest you earn in your savings account.

Plus you already have money in a 529 plan that is meant for college expenses (and cannot be used to pay student loans) - use that money for what it's for.

D Stanley
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    Wish I could upvote this more than once. Do not go into debt. Do not go into debt. Do not go into debt. – Kevin Apr 04 '17 at 22:16
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    @kevin If you have 100,000$ in cash and 80,000$ of interest-free debt, you are not in net debt. Your situation is strictly better than someone who has 20,000$ in cash. – Yakk Apr 05 '17 at 05:41
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    @Yakk Except he doesn't have it in cash, he has invested in instruments that could lose money. The small amount he might earn over four years, especially the next four years, is not, in my opinion, worth it for the reasons D Stanley listed. – Kevin Apr 05 '17 at 12:35
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    @Yakk Student loans are not interest-free. The interest is subsidized (paid by the government) while you're in school. As soon as you quit school, you start accruing the interest. That's the problem - it "feels" like free money. And the three risks I mention in my answer still apply whether interest accrues or not. – D Stanley Apr 05 '17 at 13:25
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    @Kevin OP's particular scenario has things that work against taking loan not (assets in 529; tax etc.). But if hypothetically one can take an 0% loan for 4 years and earn a return, why not? Don't even bother with stock. Throw the $100K in those high yield checking accounts and earn a risk-free 2%. No financial risk whatsoever. – xiaomy Apr 05 '17 at 15:22
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    @xiaomy The risks are not financial, they are behavioral. You need an incredible amount of self-control to leave $100k sitting in a bank account. That's a lot to ask of a college student that is bombarded with pressure to buy a better car, new books, social activities, or a house. Plus student loans to have fees around 1%, which cuts your "risk-free" return in half. – D Stanley Apr 05 '17 at 15:30
  • @xiaomy that would barely keep up with inflation, if at all. – Kevin Apr 05 '17 at 15:46
  • @DStanley There is no denying of that. But it's no different than say getting a car. You'll probably get tickets and even accidents if you drive irresponsibly, but there are plenty out there who don't. The problem IMHO is not so much about having self-control but rather financial literacy (which btw is not just a problem for students). Wouldn't you agree that it's more helpful to provide the full perspective rather than fixating on the downside? – xiaomy Apr 05 '17 at 15:47
  • @Kevin Sure but it's still better than sitting on the $20K cash. – xiaomy Apr 05 '17 at 15:50
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    @xiaomy The upside is that you get less than 1% in interest (if any) on your savings - the loan probably has a 1% fee and most savings accounts pay 1% (you might find one that pays slightly more but that's what I can find right now). And there's plenty of ways to build a credit history that don't require borrowing tens of thousands of dollars. So there's no significant upside, and serious downside risk (again, behavioral, not financial). – D Stanley Apr 05 '17 at 16:00
  • Ues you can ruin your life by going 100k into debt and blowing the 100k you saved for college while failing out and getting addicted to street drugs then killing your dealer's dog. There are thousands of ways to ruin your life. Don't blow the money you saved for college. This is an important skill (not blowing savings), and if you cannot master it you'll be pretty screwed in your life regardless. Hopefully, as someone growing up in a family where you have saved for college, you both have a safety net and you have been trained on how to have savings you don't blow. – Yakk Apr 05 '17 at 16:02
  • @DStanley That's 1% on the loan principal but could be a lot more because of the leverage. If you start with $2K, loan $100K and earn 1%, that's a 50% annual return. Plus, the severity of the behavioral risk is just so subjective and none of us can speak for other people when it comes to what they may or may not do. I just know that I'm not going to say no if someone wants to park $100K in my bank account for 4 years for free ;) – xiaomy Apr 05 '17 at 16:44
  • An interest-free student loan that you pay off before you even graduation will do wonders for your credit, and at little cost to the student. Having fantastic credit for your first major after college purchase will be a significant help. – James Haug Apr 28 '17 at 21:14
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Plus you already have money in a 529 plan that is meant for college expenses (and cannot be used to pay student loans) - use that money for what it's for.

I disagree with @DStanley, as a current college student I would say to take out loans.
Most of the time I am against loans though.

So WHY?

There are very few times you will receive loans at 0% interest (for 4+ years). You have money saved currently, but you do not know what the future entails. If you expend all of your money on tuition and your car breaks down, what do you do? You can not used student loans to pay for your broken car.

Student loans, as long as they are subsidized, serve as a wonderful risk buffer. You can pay off your loans with summer internships and retain the initial cash you had for additional activities that make college enjoyable, i.e - Fraternity/ Sorority, clubs, dinners, and social nights.

Another benefit to taking these loans would assist in building credit, with an additional caveat being to get a credit card. In general, debt/loans/credit cards are non-beneficial. But, you have to establish debt to allow others to know that you can repay. Establishing this credit rating earlier than later is critical to cheaper interest rates on (say) a mortgage.

Use your 529 (to the extent you can per year) and use other savings to pay off the loans your senior year or when you graduate.

You have made it through, you have watched your expenses, and you can pay your debt. Finish It. If you do it right, you will not have loans when you graduate, you will have a stunning credit rating, and you will have enjoyed college to its fullest potential (remember, you only really go through it once.)

But this is contingent on:

  1. Finishing College
  2. Trying to graduate as soon as possible (or say Doctorates in 6 years instead of 8)
  3. Watching what you are spending on a weekly basis.
  4. Finding alternative sources of income to pay for college (scholarships or company sponsorship)

Good luck,

EDIT: I did not realize the implication of this penalty which made me edit the line above to include: (to the extent you can per year)

For now, student loan repayment isn't considered a qualified educational expense. This means that if you withdraw from a 529 to pay your debts, you may be subject to income taxes and penalties.Source

Furthermore,

Currently, taxpayers who use 529 plan money for anything other than qualified education expenses are subject to a 10% federal tax penalty. Source

My advice with this new knowledge, save your 529 if you plan on continuing higher education at a more prestigious school. If you do not, use it later in your undergraduate years.

Liam
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    "as a current college student" - when I was a college student I probably would have said the same thing. As a graduate that had to pay back student loans for several years (even with a good income) I stand by my opinion. I suspect if you found a student that didn't graduate you'd get a different opinion as well. – D Stanley Apr 04 '17 at 17:19
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    You currently can't use a 529 to pay off student loans without a 10% penalty. There is legislation that would allow that, but I would argue that you shouldn't have leftover 529 money AND student loan debt. – D Stanley Apr 04 '17 at 17:22
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    Liam, I am the DV. The 529 issue is critical. Not just penalty, but tax on gains. 529 money really needs to come out during the same year as the college is sending your tax receipt for tuition. OP doesn't state the mix, and parts of your answer may apply, but the advice doesn't hold for 529 or College saving account (formerly the Education IRA). – JTP - Apologise to Monica Apr 04 '17 at 18:57
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    There's other ways to build great credit. I don't think this is a good idea at all. If you can afford to pay for something with cash, you shouldn't take out a loan. Ever. Period. – user428517 Apr 05 '17 at 00:01
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    " You can pay off your loans with summer internships and retain the initial cash you had for additional activities that make college enjoyable" The first half of that hasn't been possible for a very long time, and the second half is terrible advice. – Mooing Duck Apr 05 '17 at 00:18
  • @sgroves But why not? Being able to borrow at 0% is like getting free money especially when you have the cash to repay it anytime you want. Even Buffett has got a mortgage in the 70s. – xiaomy Apr 05 '17 at 01:21
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    "You can pay off your loans with summer internships" - If this were true, hardly anyone would need student loans. People work full-time jobs for years and years after graduating to pay off student loans. – Dan C Apr 05 '17 at 03:21
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    @DanC & to sgroves the current internship that I am doing this summer is paying me 4.1K a month. That should cover any tuition issues I run into going into my fifth year. I also work 30 hours a week during school to pay for housing, utilities, and food. My point: you don't need loans if you're willing to work hard enough, and most people arn't willing to make that sacrifice. To MooingDuck, the most memorable parts about college have not come from the classroom. They have come from nights of comradery and weeks I travel. – Liam Apr 05 '17 at 03:50
  • @sgroves Ordinarily I'd agree with you, but student loans are a special case. The loan is zero-interest and only usable for tuition fees. As has been said already, if you take the loan, you can pay it off with the cash once you finish your studies - but if you pay with cash, you can't use the loan to pay for unexpected expenses like car repair, medical bills, or whatever. The point of these loans, for people who could pay with cash, is so you don't have to spend your safety net on tuition. – anaximander Apr 05 '17 at 11:37
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    "retain the initial cash you had for additional activities " That is exactly what makes this option more risky! Pretty soon, you loose too much of the cash, and you still have the loan. This sounds like a good option, except that I did not have enough self control while I was in college – jpaugh Apr 05 '17 at 13:06
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    @Liam - My DV is now reversed. Good edit and sources. – JTP - Apologise to Monica Apr 05 '17 at 13:39
  • @Agent_L I agree completely - it's unconscionable to take out student loans that are taxpayer-subsidized when you have the money in a 529 to spend. I didn't know it was being proposed until I researched this question. – D Stanley Apr 05 '17 at 15:41
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Place your savings into safe interest-bearing accounts.

Take out the loans. Keep constant track of your net worth.

Having 100,000$ and 80,000$ in interest free debt is better than having 20,000$. You can always convert money + debt into less money and less debt, but you cannot always convert less money and less debt into more money and more debt.

Now, there are risks; that is why you want an interest-bearing account to place your savings in to offset the debt. This minimizes the risk. It also reduces the return.

It is arguable that you should be at your most financially risky at a young age. I'd argue that your future earnings are your by far largest asset at this point, and as a high school student going into college those future earnings have extremely high variability.

Your financial situation is extremely unpredictable; being conservative about your high-leverage student-loan + education investments is probably justified. The fact you can manage arbitrage here means you should; and if you are careful, you can eliminate risk and get almost risk-free profit from the maneuver.

If your money is in less than perfectly safe accounts, you are now doing leveraged investing and magnifying the risk and return of said investments.

If your money must be spent on college or you'll be financially punished, then you may want to consider pulling it out before the last possible legal point just in case something goes wrong.

Apparently 529 plans may not treat "paying off student loans" as a valid way to spend the money. You may need to talk to a lawyer or accountant about the legality of using these plans to pay off student loans, and the tax/penalties involved.

Yakk
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It's not a question with a single right answer. Other answers have addressed some aspects, my case may provide some guidance as to one way of looking at some of the issues.

When I had student loans, the interest rate was RPI¹ and I could get more than that as the return on a savings account. At the time I could get a whole year's worth of loan at the start of the year, save it, and draw from the savings, partly because I had a little working capital saved already. Importantly in my case, the loans were use-it-or-lose-it: if I didn't take the loan out by about halfway through each academic year, it was no longer available to me.

The difference in interest rates was probably similar to what you can get with a careful choice of savings account and 0% on the loan (I did this in the 90s when interest rates were higher).

Over a four year degree the interest I earned this way added up to no more than about £100, which went someway towards offsetting the fact I would be paying interest after graduation. If you can clear the loan before you pay any interest it would give you a return, but a small one that could easily be eroded by rate changes or errors on your part (like not keeping on top of the paperwork). It still may be beneficial to take out the loans depending on your capital needs -- in my case it made buying a house after graduating much easier, as we still had money for the deposit (downpayment) and student loan rates were much lower than mortgage rates (100% mortgages were also available then, but expensive).

¹ RPI stands for retail price index, a measure of inflation.

Chris H
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  • "The interest rate was RPI". Sorry, what does that acronym mean? – JTP - Apologise to Monica Apr 06 '17 at 00:08
  • @JoeTaxpayer, sorry I assumed that was international but it must be a UK term. It stands for retail price index, which is an inflation measure. – Chris H Apr 06 '17 at 05:42
  • Thanks, Chris. For our general rate of inflation, we use CPI, consumer price index. But our loans, if variable, tend to be tied to government paper (Treasury Bill) or "Prime Rate", a bank-generated rate used for loans. It's a big world, I'm in my 50's and still learning. – JTP - Apologise to Monica Apr 06 '17 at 09:26
  • @JoeTaxpayer we use CPI quite a lot too. Anyway, now I'm on dekstop I'll edit in a link/explanation. – Chris H Apr 06 '17 at 09:31
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I think the answer to this question depends on how much you trust yourself. Most people are wonderful at deceiving themselves. I'd personally not trust myself; I'll use Liam's points for the pitfalls some people get into.

You can pay off your loans with summer internships and retain the initial cash you had for additional activities that make college enjoyable, i.e - Fraternity/ Sorority, clubs, dinners, and social nights.

This is actually the risk I've seen many people do. They'll blow their money in one semester under the assumption that 'they'll just earn more in Summer and keep it for expenses or the future."

Another benefit to taking these loans would assist in building credit,

No Credit (in the USA) is actually a good standing. Many sensible banks or credit unions will happily give people with No Credit a loan. This makes intuitive sense if you think about it. Imagine two people with the same income. One owes money regularly to multiple sources and the other has no debt obligations. Which one are you loaning money to?

Simplifying things a lot: Great Credit is best, followed by No Credit, then Good Credit, and then Bad Credit. The advantage of Great Credit over No Credit is simply that some institutions in some sectors don't have the policies in place to process No Credit people (No Credit people plan to not apply for credit often, for self-explanatory reasons, so this is a mote point).

Lan
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    No Credit is a question mark and risk managers don't like variables they can't measure. You can't assess the habits of the person because there are none. Great credit has all those and they look shiny. Don't understate. – Mindwin Remember Monica Apr 04 '17 at 19:52
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    Not my specific field, but I would flip no credit and good credit in terms of how attractive they are to lenders. No credit people can typically find someone to work with them on small ticket items, but it is much more difficult for larger things like mortgages. One of the key things the lenders look for is a consistent history of on time payments. Why should they take a six figure risk on someone that has never had to commit to an ongoing payment schedule? – Rozwel Apr 04 '17 at 20:43
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    -1. Even if no credit doesn't hurt, delaying credit building means a shorter credit history and a lower score. So if you are going to borrow money at some point down the road, why not build a history early on? – xiaomy Apr 05 '17 at 01:12
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    No credit record is awful. The older you get, the worse it is. Getting anything besides small loans is pretty difficult without actual history of repaying loans. – le3th4x0rbot Apr 05 '17 at 09:07
  • @Rozwel Why would a person with no history of being in debt be riskier than someone with a long history of being in debt? Someone with No Credit can (should) be able to provide history of payment, tracks of rent receipts, etc... – Lan Apr 05 '17 at 15:58
  • @BaileyS "Getting anything besides small loans is pretty difficult without actual history of repaying loans."....if you have no debt......what are you getting small loans for? – Lan Apr 05 '17 at 16:00
  • @Lan Lenders do not look at rent payments, they look at credit history reports. A person who has regularly paid loans before, and scores well in a credit risk model, is very likely to make payments as agreed. That is the actual point of credit scores. Avoiding credit completely until applying for a mortgage is a huge disadvantage. Not being in debt is good, no credit history is bad. – le3th4x0rbot Apr 05 '17 at 18:20
  • @Lan because someone looking at credit history can't know what the person with no history has paid. Any and all documents coming from the no-history may be falsified. There is no reliable way to tell where their money is going- is it in savings? Well, that's good- they can pay from that. But if it was all impulsively spent they're a risk (they may not have money when they are supposed to pay). Someone who has a strong credit history is known to be competent at making the payments; someone who has no credit history has not been vetted and is thus a liability to the creditor. – Delioth Apr 05 '17 at 19:58
  • @Delioth "But if it was all impulsively spent they're a risk (they may not have money when they are supposed to pay). Someone who has a strong credit history is known to be competent at making the payments;" The person WITH a credit history has a confirmed history of impulsively spending more than they have....why you don't realize that is baffling. Being denied credit, for someone who doesn't use credit is a non-issue as well. It is the false premise fallacy. The only thing they'd likely need a loan for is a home (and in that case, many institutions are happy to do manual underwriting). – Lan Apr 06 '17 at 12:46
  • @lan Every time a lender gives out money they are taking a risk. As others said, lenders want evidence that you can be responsible and pay back what you have borrowed in order to justify the risk they are going to take. Someone with no credit history is an unknown. Maybe the borrower will pay the money back, maybe not. This unknown factor increases the level of risk the lender is assuming in such a transaction. So they are much less likely to take a large risk on such an individual, or if they do they are going to impose a higher interest rate as compensation for the increased risk. – Rozwel Apr 06 '17 at 16:27
  • @Lan There is a significant logic flaw in assuming that someone with a credit history is impulsively spending more than they have. Yes they have borrowed money, there is absolutely no evidence that they did so on impulse. There are any number of scenarios where using credit makes sense, even if you have the cash in hand. – Rozwel Apr 06 '17 at 16:35
  • @Rozwel "There are any number of scenarios where using credit makes sense, even if you have the cash in hand." Correct but we're not talking about single events. We're talking about numerous occurrences. People with occasional charges to credit that they pay off quickly have poor credit; it is only people with frequent bouts of being in debt that have good or great credit scores. – Lan Apr 06 '17 at 16:53
  • @Lan That is incorrect. A person who uses credit as needed and pays it off promptly generally has an excellent credit score. The three primary factors in determining your credit score are: Length of History, Percent of Utilization, and Negative Reporting. Your score is generally low for one of a few reasons, 1)You have a history of failing to pay on time. 2)You have maxed out all of your existing credit. 3)There is not enough recent data to analyze how well you can mange debt. – Rozwel Apr 06 '17 at 17:20
  • @Rozwel Exactly.... – Lan Apr 06 '17 at 17:24
  • @lan you seem to be contradicting yourself. In your answer (which I generally consider to be decent) and prior comments, you assert that having no credit history will rate better than having a good credit history. Yet this last comment acknowledges that having no history gives you a poor credit score. So how does having a low score from no history make you more attractive to a lender than someone with a good credit history? Regardless we are off topic for the question that was asked and I am abandoning this thread. – Rozwel Apr 06 '17 at 18:18