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“Should I invest my student loans?”

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Zach emails about his student loan money:

Now for the most part all of that money will be used to do things like pay rent, and buy groceries, but when I’ve calculated it out, there’s around $1000 left per semester minimum, and more if I can be frugal about how I spend it.

My questions was, do you think it would be smart to turn around and pay off part of my loans with the extra cash, or could you recommend me a direction to maybe take this extra money that I have, and invest it to make a return? I know right now that I could either drop it in my ING savings account which is at 4.5% or put it into a money market account at my bank which is about 4.5% also. Other than that I wouldn’t know where to begin.

The problem with investing money in the short term is that it’s dumb. Sure, you could make a few percentage points — or you could lose most of it. Short-term volatility is very high, while time (and good investing choices with low fees) smooth out short-term volatility. As I’ve written before, time pressure=bad decisions. For example, I remember when I was a sophomore, we hosted this prospective freshman in our room for Admit Weekend. This guy left our room with a single decree: “Guys,” he said, “I’m not coming back until I hook up with a hot girl tonight.” My roommate and I looked at each other and laughed and laughed. Then we told him to just pack his stuff and take it with him — he wouldn’t be coming back, and it was nice to meet him. When he sheepishly came back around 3am, alone, I believe that moment of happiness will rival even the birth of my children. Setting a rapid timetable for getting ass, it turns out, is difficult.

Back to student loans. Do you want to invest your student-loan money for the possibility of making just $7.50/month (9% returns) but possibly losing some/most/all of it in the short-term? “But Ramit,” you might say, “I’ll just invest it in something safe so I can’t lose it.” Lower risk = lower rewards, so if you invest it in a safe government bond, you’ll earn about 5% — basically your savings rate. You need time and more capital to grow your money, not $1,000 and a few months. That’s the domain of get-rich-quick quacks, something I hate. Remember, the first thing I ask when someone wants to know about investing is, “When do you need this money?”

Ultimately, it comes down to risk and reward. This is why I find those 0% credit-card games so moronic. These are the ones where people get 0% interest money from their credit cards and transfer it around to earn interest on relatively large sums of money. Sure, you can make a hundred bucks a year, or maybe even a few hundred, but the risks of time, mismanaging the process, and screwing up your credit score just aren’t worth it to me. Plus, I’d rather do something useful and sustainable instead of spending a year getting $200 band-aid.

If it were a college student and I had some money left over from my student-loan account, I’d put it in a high-yield savings account like ING or HSBC and let it get about 4.5%. (Note that this would earn you about $4/month in interest, just about enough to buy Sisqo’s greatest hits on iTunes.) Separately, the most profitable thing I could do would be to learn about investing, asset allocation, and building an infrastructure to manage my personal finances.

The basic messages here are:
Risk and reward. Before you get overly excited about something, ask yourself if it’s worth it. You might make $200 in a year, with the possibility of messing up your credit for doing those stupid balance-transfer games? Not worth it.
Sexy vs. rich: Making it sustaintable. Are you building a long-term infrastructure or are you doing something short-term and dumb to distract yourself from the hard work of learning about real banking, budgeting, saving, and investing? Do you have a savings account? A Roth IRA? An investment account with proper asset allocation? Have you bought even one personal-finance book? (Here are 50 books I recommend.)

Learning and building a system may not seem as sexy as INVESTING IN DERIVATIVES AND SHORT-TERM SECURITIES!!!!11*#! but it’ll damn sure make you richer over the long term.

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  1. Ultimately, what it comes down to, is doing this could result in a jail term.

    The funding from a student loan, according to the contract (which you read, right?), *must* be used to finance education expenses, which include tuition, textbooks, room and board, et cetera. It does not include exterior investment. That’s not an education expense. Do not invest money obtained from a student loan.

  2. Or here’s an idea… the extra money back on the loan….and don’t take out student loans for rent and groceries!! This is coming from someone who took out a reasonable amount in student loans and just finished busting my butt paying them off. I think it’s incredibly irresponsible and stupid to take out student loans for living expenses (uh, get a job!) and even stupider to keep an overage and debate how to invest it! Student loans will GREATLY impact you ability to get a mortgage later in life, especially as lenders are tightening up on who they’ll lend to. They also GREATLY affect your freedom once you graduate. Student loans are a real pain to have to pay on every month and they really decreased my choices after graduation. You never think about it when you’re in school…but you have to pay those puppies back. Work harder now, take out fewer loans and you will be rewarded when you graduate and you aren’t having to pay on the stupid things.


  3. Ramit, I am in love. If my parents weren’t so small minded (wrong kind of Indian… Even in this day and age, i know…) I would marry you tomorrow. Love your site. There is a lot of useful information here and I have learned a lot. It doesn’t hurt when you call people morons, either. heh.

    My question is this: Is is worth it to contribute to a company RRSP (I’m Canadian) if there is no company match? Are there any downsides to doing this? Also, what would you consider to be a high Investment Management Fee? Ok, that’s more than one question…

    Thanks for your help. Sorry, I know this isn’t related to the student loans post…

  4. The guy mentioned about putting it in a savings account. If this is legal and he is disciplined it could make sense. When he graduates, if he is short of money he’ll have access to this cheap source of credit to help get established. I didn’t think about investing in anything riskier till I had $10-20k.

  5. If you have money sitting around, about $1000 in a totally safe bank account is not a bad thing. If you are NOT working to pay for school while in school (and even if you are, but it is lots harder), then you should be busting your butt to get out in as little time as possible – I finished my BS in 3 years.. That reduces the total of your living expenses. In some majors that is more possible than in some others. If you have parents willing and able to help you in an emergency (a real emergency – having spent your rent money on beer does not entitle you to this kind of help) then you can pay anything beyond that initial cushion back towards the loan.

    When you graduate, buying fancy living room furniture is not a good use of left over funds. Pay them back to the loans, and get your aunt’s old sofa to start with.

    Getting a little farther afield – placing well on AP tests can cut your time-to-BS. So can taking courses at the local college while you are in high school if that option is offered – they count as high school and college credit (at discount or paid for by your high school), that can go toward cutting your undergraduate time. Parents, take note.

  6. Great post, Ramit. I would say one other thing Zach might want to consider would be how good he is at leaving his savings alone. If he puts it in an ING/HSBC/Etc account and it is earning him an extra couple of dollars a month, that’s an extra few dollars to put towards the loan at some future time. However, if he has a propensity to dip into his savings, he might be better off putting the money on the loan right away. As you said, looking at risk vs reward is important. For those that are good at leaving their savings alone, there is very little risk in letting it sit and accrue interest. But for those that tend to “borrow” from their savings, the risk is much higher that they won’t have that money to apply to the loan later on.

  7. While you are in school, just have fun. Spend your money on beer, dates, and movies. Don’t take extra loans out but if it happens enjoy it.

  8. Punam,

    As a Canadian, RRSPs are a great idea… but there is no reason to do it through your company unless they have some sort of incentive (matching is very rare in RRSPs, whereas it is pretty common in pensions).

    The reason they are useful is because they act as a form of income smoothing – don’t think about them as a way to retire but as a way to shelter your money from taxes, both for investment purposes and against your current income. When your income sinks (say, you do start your own business, you get laid off, etc) you can withdraw the money – you pay tax in the year you withdraw, which you can time to be less than when you put in.

    You need to plan for how you will use your RRSPs for them to be effective… but using them makes a gigantic difference (for me- 5 years working, roughly 33,000 in cash for me, although that was directed towards my mortgage, meaning 20,000 is an IOU to the RRSP, meaning 13,000 clear I just wouldn’t have otherwise).

    And of course, you don’t pay taxes on the investments in the RRSP, which would allow you some diversification into bonds/income if you care about that stuff (eliminates the drawback of high taxation).

    Forget about the MER if you are just starting up your RRSPs – you don’t have as much flexibility as the Americans do. Just go to the bank and have it set up, go over the options with a decent advisor (if they don’t bring up self-directed RRSPs, find another bank). Once you have enough money (ie: 20k+) you can worry about buying into a better fund.

  9. Mark Armendariz Link to this comment

    I might be mistaken – as it’s only an excerpt – but it seems you overreacted to the question. As far as I can tell, the person was asking if he should just put his extra money in an interest bearing savings account without even the mention of riskier investments.

    You went on a rant about risk / reward and then said he should do what he was asking. Don’t get me wrong, I agree with the intention of the article, it just doesn’t seem to have anything to do with the quoted email.

  10. Take out the risks and just pay off the student loans