Monday, April 24, 2006

Viewing certain educational loans as FICO boosters, and low fixed APR for life balance transfers (Edit: New Strategy)

EDIT: See below for additional strategy

Most people tend to approach student loans through two typical lenses -- insist on paying them off ASAP, because all debt is bad -- and ignoring them as much as possible, because they're just student loan payments.

Neither approach is particularly elegant or optimal; though the first approach likely helps you reach financial stability sooner and is safer. I thought I'd point out a few little-known quirks of student loans that provide even better optimization strategies.

Some caveats:
I assume the all loans under discussion are Direct Loans from the government, and either subsidized (you don't pay interest for them while in school) or unsubisdized (interest accrues on your loan, but you don't need to pay it until after you leave school).
I also assume that whoever follows any of these instructions, will be perfectly rational w/respect to the managment and use of the resultant money. (In other words, the person won't buy more consumer goods because there's extra cash in the bank.) This person is unlikely to exist, but if s/he does, hopefully s/he is the kind of person who'd read my blog :)

There are also some scale issues -- I assume that your loan is large enough to make this workable. This is clearly the case for law student and doctors, say, or people attending expensive colleges (w/wealthy, but stingy parents) -- but at some point, if you only have a $500 loan, these strategies may not be appropriate. (Typical loans over 3 years for a law student, ~100k at even a 2nd tier, private school)

1.Typically, school loan rates are _lower_ than risk-free rates, though they also move in lagged tandem over time. The elementary strategy is either to bet that the risk-free spread over student loan rates will increase over time (and invest money you'd otherwise put towards repayment into a liquid savings account), or do a duration match w/the loan, using bonds, which may locks you in for up to 25-30 years. Only caveat is that consolidating through the US government takes your current rate and rounds it to the nearest .25% to get your fixed rate. In practice, the benefit is even greater (as is the risk), if you instead use your extra money wisely, but in riskier ways than just a savings account or T-bill.

-The money you save must be spent with utter care if you don't opt for either of the 2 previous options. This is the difficult part, to not feel like you have more money in the bank, ignoring the loan, and thus ratcheting up spending-- this is what economists (Ok, not econmists, just me) call illusionary marginal propensity to consume.

-If you _really_ want to lock in the trade, structure the savings vehicle you have to duration match that of the loan...30 years treasuries so you can't easily spend it!

2.Looking at subsidized loans -- here's the wonderful part -- as long as you enroll in at least 1/2 time a semester at a accredited college, they continute to pay the interest for you, so you're effectively holding down a HUGE 0% APR transfer for life (if you meet conditions, etc). If I were more rent seeky, and less easily guilted, I'd find the 2 cheapest accredited colleges in the country that allowed online only, or else sign up and flunk the classes if need be. I'd of course see if I could take out more student loans to do so :) EDIT: 4/30/06: To really spread out your expenses, keep in mind that after you stop taking classes, there’s a grace period of something on the order of 6 or 9 months – in effect, this may mean that you only need to take two classes every other semester to qualify.

3.Even if the loans are not subsidized...
Lock the loans in at the current low rate and you still then have the equivalent of borrowing at below money market rates in large size.

4.Either way, opt for the slowest acceptable payment plan possible (this can change later on since there is no prepayment penalty).

5.Tax effects
Can someone enlighten me -- if interest is taxed normally, does the interest accruing on unsubsidized loans while you're in school count as (negative) income for AGI purpose, insofar as it meets the student loan interest deduction? If so, that's another boost.

6.Credit scores:
Increasing average account age, having a particularly old account (since FICO inputs include the oldest account's age) -- these are all big plusses for one's score. Student loans can be carefully milked for
FICO boosting as well as profit potential.

One ancillary benefit to your credit score is that the mix of types of accounts is another FICO input, and installment loans w/lo payments are generally considered plusses rather than minuses.

If you're a FICO junkie, don't pay off the student debt completely and then let the loan languish as a closed account on your credit report. Instead, try to get a deferral, or else make smaller payments whenever possible (which is usually fine w/colleges if you prenegotiate), and pay off the school loans as slowly as possible. I haven't ever seen a neg-am student loan, but not for lack of trying. (Note that I'm NOT sacrificing money forFICO, since the loan APR is presumably under riskfree.)

7.Extra 0.25% edge from making automatic debit payments on your loans
-- how sweet is that?!

Throughout, I'm assuming that if you've followed the previous steps, you are the utter master of your appetites. If you follow these instructions, so long as the rates lag the riskfree rate in the right direction, you'll have a hard to screw up solution that earns money, and will one day be the oldest installment loan tradeline (and perhaps oldest line period) on your credit report.

EDIT: Thanks to the poster who suggested that an alternative to 2 throwaway classes, might be classes that you have personal interest in, such as pottery for college credit, or college-level classes at a culinary institute that offers AA's or BA's...This is something I've considered in the past, but not something personally doable at present, given my schedule/exhaustion levels.


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