Loans, Debt, and Investment

Soren Sugalski, 27

One of the most striking attributes of our school is its near 100% college matriculation rate. With our helpful college counseling team, Ensworth seniors can reach universities across the country and pursue a variety of interests. This level of freedom has a strong positive impact on prospective students but can also make admissions appear ever more daunting. In addition to this complicated decision, college enrollment introduces new responsibilities of adulthood, such as greater self-regulation and financial independence. Some students are fortunate enough for their parents to cover parts of their transition, but not everyone is so lucky. Including the eighth of people that receive scholarships, the average student in America graduates college with $30,000-40,000 in debt. Most young graduates start off at a disadvantage, with loans to pay, no job experience, and relatively little knowledge of how to manage their finances. Even then, there are more loans that need to be taken out for car expenses, rent, and new bills. Unfortunately, many people will spend a lifetime recovering from debt. Young people are also disadvantaged by their lack of understanding in early investment, which can make a big impact on the age they retire. Money that is invested early on in life will be able to grow for the longest time and will be worth more in the long run. For example, money that is invested in the stock market is predicted to double in value every 7-10 years and can do so multiple times in a lifetime. So, how can you save up money while you do relatively nothing?

Before we touch on investing, let’s take a look at the unfortunate realm of debt. Much of the financial world is based on interest rates, which can be somewhat of a double-edged sword. When it comes to loans, you want your interest rate to be as low as possible. Interest rates are the primary way that banks profit, charging a certain percentage of the money they lend you as payment. On the surface, they may seem very simple. If you take out a one year loan of $100 at an 8% interest rate, you would assume that you would pay $100 toward the loan, and a total of $8 as interest. Unfortunately, rates aren’t so easy to understand. While the monthly payment on a loan never changes, interest payments are based on the ongoing debt in the account. Let's say that your monthly payment is $1,500 for 20 years, and at the beginning of this loan, you owe $200,000. Initially, the total amount of money you still owe is high, so most of your payment is going to go towards paying off interest (lets say $1,300/1500). That means that only $200 will go towards the paying off principal, and you will still be $199,800 in debt. On the next payment, you have slightly less debt, and the interest that you are paying will decrease slightly. Maybe your second payment will put $210 toward the principal, and less of your payment will go towards interest over time. At the end of a loan, you may only have to pay $100 in interest, and your $1,400 will go towards paying off the remaining debt. For this reason, loan duration plays an important role in the total amount of money you pay.

The longer the duration of the loan, the lower your monthly payment can be, since you have more time to pay off your debt. However, long duration loans are actually much more expensive. If you were to loan $200,000 for 10 years at 8% interest, you would end up paying $91,000 in interest over time. For the same loan with a 20-year duration, you would pay more than double the interest, at $201,000 in total. Short duration loans are always a much better option, even though the monthly payments are higher than long-term loans. Generally, it is a good idea to pick the shortest loan you can, as long as you can consistently make the payment. Lower interest rates can also significantly decrease the total cost of a loan. If we look at the same $200,000, twenty-year loan from before, a slightly smaller interest rate of 7% can lower the total cost of the loan by $30,000. Low interest loans can be obtained by increasing your credit score, which is a measure of how likely you are to make your payments on time. Equifax, Experian, and TransUnion are the three main credit reporting agencies, which use your payment records to calculate credit. Key factors include debt payment history, credit use, and the frequency at which you open new accounts. A good credit score will range from 670-730, while an excellent credit score is anything greater than about 750.

Now, let’s look at the other half of the financial world: investment. The key to a successful investment plan is to start early, no matter how little you actually put forward. Compound earnings help you grow your money fast, by generating interest on the ongoing balance of the account, not just the amount you put down originally. Many investment plans are built towards saving for retirement, such as IRA and 401k plans. While both plans share a common goal, 401k plans are created for employees within a company, where employers may or may not match your contributions to the account. Individual Retirement Accounts (IRAs) may offer more flexibility than a 401k plan but are not supported by your employer. Many retirement plans are also subsidized by the government, primarily through the form of tax deductions. Money placed in a traditional savings plan is not taxed before it is added into the account, so a portion of your annual income becomes tax free. The downside to these accounts is that you still have to pay taxes when you finally withdraw the money, often at a higher tax bracket. Roth plans are the opposite of the Traditional plans, since they contribute post-tax money to your account. This second type of plan still allows you to grow your savings tax-free, paying taxes before instead of after adding your funds to the account. Neither plan is truly better than the other, but the best choice will depend on your financial situation. If you expect to be in a higher tax bracket when you retire, you will save more money by choosing the Roth plan. If you think you’ll be in a lower tax bracket in the future, the Traditional plan is probably the better choice for you.

If you want to invest more money or need to have more investment flexibility, retirement savings accounts are not the only type of plan you can get into. IRAs come with an investment cap of up to $7,000 (for people under 50), and may be unavailable to people with high annual earnings. Additionally, Both IRAs and 401ks restrict your ability to withdraw money from the account, since they are intended for retirement savings. If your investment goal is not to save for retirement, then you might want to consider a taxable brokerage account. These accounts are not supported by the government and give you access to a wide range of investment options. Within a taxable brokerage account, you can choose to invest in any combination of stocks, bonds, mutual funds, and exchange traded funds (ETFs). The best option for you will depend on your investment goals, as each option comes with its own benefits and drawbacks. Stocks are on the higher risk end of the spectrum, since their values can be the most volatile. When you buy stock, you purchase a small portion of a certain company, whose cost is dependent on the share price. In order to mitigate the risk of a company’s share prices dropping drastically, most people will invest in a variety of stocks to lower the potential loss. Bonds are a much safer investment option than stocks, though they have lower rates of return. A bond is a loan issued by companies or the government, which is generally used to finance a new project. Unless the company fails, they are typically a reliable way to make a small profit. Finally, mutual funds and exchange traded funds are pre-arranged investment portfolios, which are designed to balance risk and profit. There are a few differences between the two, such as the way they are managed, but both follow the same principle of pooling together a variety of investments.

If you want to try investing are on the fence, it is never too early to start. Many people believe that it is not worth it to get a job early on in life, since they will earn much more money as adults. While this may be true, if you get a job and invest your earnings early on, you will find that they grow the most over time. Additionally, it is always helpful to have a little bit of money set aside for the random expenses of life. You also don’t need to be an expert; you just need to know enough to make smart, educated decisions. Careful choices will not only help you choose the right investments, but keep you from accumulating debt from bad loans. If you are worried about making the wrong decisions, there are professionals that you can hire to manage your investments. Financial advisors usually charge a percentage of the money they manage, which is generally less than 2%. This allows you to have a more off-hands approach and lower your risk of loss. It is also okay to put off investing if it feels too risky, because it is definitely not for everyone. Some people might find themselves able to make better decisions later in life, when they are more educated and financially independent. If you want to learn more right now, or are curious about this topic, you can always try Ensworth’s very own Investment Club.