Should I take student loans for the purpose of opening a Roth IRA?
April 9, 2010 7:24 PM   Subscribe

I may have an opportunity to take out an educational loan that I don't need. It is a federal 6.55% unsubsidized loan. Would it be worth it to take the loan out to start a Roth IRA?

In about a month or two, I will be getting financial aid information for the coming school year (for grad school). I've already been hired for an on-campus job which will cover a decent amount of the education cost, so it will not be necessary to take out the full loan amount I am expecting to receive (which I am 99% sure I will be offered). Because of this, I will have the option to accept or decline a few thousand dollars in loans that I DON'T need (assuming I stay employed for the school year). However, I'm debating whether it may be beneficial or not to get the loans and then dump it into a new Roth IRA with Vanguard.

The loan would be a federal direct Stafford loan, unsubsidized, with a rate of 6.55% (after a 0.25% reduction if paid through EDA automatic payments). The return on the investments in the Roth IRA (which will likely be about 90% stocks and 10% bonds) is not guaranteed, but in the long run, could be anywhere from 7-10% (in theory).

The pros of taking the loans and getting the Roth IRA would be:
1. Starting the retirement account early. This is good because of the long-term growth and the Roth IRA annual limit. Also, my planned career path has the potential to earn enough income to become disqualified from Roth IRA contributing (some 6+ years of work experience later).
2. The money I take out for loans isn't taxed, so contributions to the Roth IRA now should in theory, never be taxed (correct me if I'm wrong?).
3. If for some reason I become unemployed during my graduate education and am in drastic need of money, I should be able to take money from the Roth IRA without penalty because it would be for the purpose of educational expenses.
4. Anything you guys and gals can think of?

The cons would be:
1. Having debt (obviously) at a not-so-great 6.55%. Because the loans are unsubsidized, the interest must be paid immediately after taking the loans out (thus, during the school year). Having more debt would of course lead to the inconvenience of having larger monthly loan payments. Additionally, in the extremely unlikely situation I declare bankruptcy, these loans would still be standing.
2. The uncertainty of returns on the Roth IRA's investments vs. the certainty of the loans. If I make over 6.55% interest on the Roth IRA investments it would be beneficial, but there is no guarantee.
3. Anything you guys and gals can think of?

What do you think?
posted by NeoLeo to Work & Money (15 answers total)
Terrible, terrible idea. This is EXACTLYwhat caused the housing/financial crisis. People bought homes with borrowed money thinking that, in theory, house price appreciation will beat the rate on the adjustable rate mortgage. Banks borrowed in the short term market (think overnight market) to speculate on mortgage securities thinking that, in theory, most people would pay their mortgage, when push comes to shove. We see the disastrous consequences playing out in real time. Borrow what you NEED, NOTHING MORE. Live like Walden, until you make real money to party like a rock star.
posted by SeizeTheDay at 7:29 PM on April 9, 2010 [1 favorite]

Terrible, terrible idea. This is EXACTLYwhat caused the housing/financial crisis. People bought homes with borrowed money thinking that

No it's not. It's nothing like that. The problem with the housing market is that people borrowed money using ARMs and then spent it. If NeoLeo takes the money and saves it, he'll be able to pay back the loans if need be.

However, given the low difference between the interest rate and potential rate with the stock market it may not be that good of an idea, there's only a 1-3% difference. And as we all know the stock market is not all that stable.

But as long as he's able to make payments it's not that bad of an idea.
posted by delmoi at 7:40 PM on April 9, 2010

You don't mention this as a potential problem, but are you quite sure that you are permitted to invest education loan money in this way under the terms of the agreement you would sign? Look into that before doing anything.
posted by chinston at 7:41 PM on April 9, 2010

I wouldn't do it -- because the potential to lose it is there but based on averages you don't stand to gain *that* much from an upside.

The only reason I'd suggest using a student loan for something besides an education is if you happened to be about to buy a car and the loan rate you can get for the car is higher.

FYI I am still paying off loans for my RENT the first year in grad school, which I totally regret doing now. I wish I had gotten a job.
posted by thorny at 7:51 PM on April 9, 2010

You only benefit if the interest rate you are paying is less than the return on your investment after fees. In the event that you suffer major losses, you are still on the hook for the money. Let's say that it is $10,000. The interest you are paying is about $65. Say you make 8% a year on it in increased capital, since there is no way you are getting that in interest in the current market. AT the end of the year you will have $10,800, minus the (12 * 65) = $780 you paid in interest. Congratulations, you just made $20!

That is the upside. The downside is that should whatever you invest it in fall, you now owe on the capital. So say you invest in stocks, and the market drops 8% instead of going up, you just lost $800. Now you have to make almost 9% just to break even, while still servicing the full $10,000 of debt.

It seems to me that you have very limited upside and potentially huge downside. Plus it is debt that you cannot get rid of out of bankruptcy. There is no way to safely invest it and cover the costs, plus there will likely be fees that would also cut into your earnings. Lots of risk, little reward. I say no.
posted by procrastination at 7:53 PM on April 9, 2010 [1 favorite]

I don't think you're actually allowed to do this, but even assuming you are, you're banking on beating the S&P 500 using borrowed money coming out of grad school. You're assuming quite a bit about your future prospects, unless you're some kind of rock star in your field, in which case, you don't need to consider this either. Student loans aren't an easy source of investment cash. If you're good enough at investing to secure that kind of return, you should do it with money you can stand to lose.
posted by StrikeTheViol at 7:55 PM on April 9, 2010

Thinking about this more, it is only sensible if you can arbitrage the difference between what you pay and what you earn safely. You can't. It is therefore not investment, but speculation. Should you choose to do this, I would encourage you to go to Vegas, put it all on black and get it done with. That way you can either pay it back immediately, or start going about the slow business of earning enough to pay it back. Either way, don't draw out the pain.
posted by procrastination at 7:58 PM on April 9, 2010 [1 favorite]

This is very risky. Consider the S&P 500 5 year annualized returns. For the past ten years, the annualized return over the 5 previous years has been less than 6.55% for seven of those years and only more than 6.55% for three of those years. In half of those ten years, the return has been negative. Are those odds you want to take?

Just because this investment would make a (small) profit on average, over very long time periods in the past, does not mean you will make a profit during whichever period you invest. You stand a good chance of loosing money on this.
posted by ssg at 8:02 PM on April 9, 2010 [1 favorite]

Are you sure they'll let you take out the higher amount? You have to report any new income sources that you will receive during the school year, so if your fin aid office doesn't have this new job info, they will need to have it to adjust your aid package. If you don't report it, and take the money, you could possibly get in trouble with the government and your school-- such things as getting your aid cut off in the future.
posted by ishotjr at 8:08 PM on April 9, 2010

And even if you can get the money, I would absolutely not do this.
posted by ishotjr at 8:10 PM on April 9, 2010

Response by poster: Okay, the general consensus is a pretty clear-cut "don't do it". I was honestly 50/50 on what to do, so having the perspectives of other people certainly helped.

As to whether or not I could have done this using the educational loans: I believe it may be somewhat of a gray area to a certain extent because part of the total cost of attending school includes a few thousand dollars set aside for "personal expenses", which seems to be not clearly defined anywhere. Either way, if I went about doing what I mentioned, I would have taken a good look at the fine print to determine to what extent I could have done it.

Thanks everybody!
posted by NeoLeo at 8:30 PM on April 9, 2010

To the people wondering if you can do this, money is fungible. The OP has a job, the income from which will cover the cost of school. If the OP pays for school using a loan, then the income from the job can be put into the IRA.

Also, with an IRA you aren't looking at short-term returns. Since the OP is in school, it's likely that the money will be invested for more than 40 years. Even if the investments can't beat the interest rate on the loan for the life of the loan (which is likely to be less than 40 years), since you can only contribute a limited amount to an IRA each year, there is an opportunity cost for not getting money invested now. Is that opportunity cost more than the interest on the loan? I don't know, but the math is a lot more complex that people are making it out to be in their answers.
posted by willnot at 10:27 PM on April 9, 2010 [1 favorite]

One way to work through the math is to ask at what interest rate this transaction would make sense. For example, if the loan was at 0% you could put the money into bonds and make the difference. If the loan was at 10%, there is no way that it makes sense. Somewhere in the middle is a point where it changes. I expect that point is well under 6%, but you should not take financial advice from grad students!
posted by cjemmott at 5:25 AM on April 10, 2010

Just to argue for the other side: if you graduate and start earning a high income right away, then you may have a hard time getting much money into a Roth. Currently, anyone can contribute to a traditional IRA and roll it over regardless of income, but that loophole may be closed. Since your tax rate is currently very low, it's a great time to put money in a Roth account. If, upon graduating, you earn a high income then you can pay off the portion of the debt that you invested, so you were only paying 6% interest for a short time. So the question you need to answer is whether the tax savings more than offset the interest payments. That depends on a lot of assumptions which I don't have the information to answer. And if you don't think you're very likely to have a high income soon after graduating, I don't think it makes sense.
posted by jewzilla at 1:28 PM on April 10, 2010

Jewzilla is right, if you're going to be making a good salary when you graduate. $5k, compounded for the next 40 years is a ton of money, all of it tax free. Paying off a $5k loan when you have a good salary is very do-able, you'll pay now where near the 6% rate if you pay it off early.
posted by gus at 8:19 PM on April 11, 2010

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