Subprime Student Debt Is a Huge Red Flag

by Alyssa Oursler | February 5, 2013 8:18 am

A few weeks ago, I offered four simple steps[1] for college grads owing a pile of student debt — know your loans; beware of interest; don’t be short-sighted; and be smart.

These might sound like basic tips, but everything from interest accrual during deferment to alternative payment plans is often overlooked and overwhelming. Unfortunately, too many students don’t consider how much they can afford to borrow in the first place, making handling those loans after college even more difficult.

The Wall Street Journal recently ran an article[2] featuring more than a few alarming stats. Late last year, around 26 million consumers had at least two open loans — more than double the total seven years ago. On top of that, more of those loans are being issued by the federal government, too — over 90%.

This is a notable shift for two main reasons. To start, the interest rate on said loans has been on its way up. As the WSJ explained, “Most federal loans now carry interest rates of 6.8% or 7.9%, versus a rate of 2.875% on federal Stafford loans in May 2005.”

The second issues is that Stafford loans account for 75% of that huge chunk of federal loans. That’s bad news, as the loans have no credit standards whatsoever. Uninformed or overzealous college-goers can dig themselves up to $57,500 in debt for a four-year degree with just a quick online application.

The result? An increasing number of borrowers are at a high risk of default. Take a look:

The Journal summed up this implications of this reality quite simply: “The high debt loads could weigh on consumer spending and the economy.”

As I mentioned in a previous article[3] — such loans are holding back spending by those who have them … and could do so for years. Subprime borrowers — again, borrowers who are at risk to not pay back their loans — have a slim chance of shelling out cash for a house or other big-ticket item … or for getting approval for a new loan even if they wanted to.

This reality could hurt a wide variety of sectors for years to come, from homebuilders like Toll Brothers (NYSE:TOL[4]) to appliance-makers like Whirlpool (NYSE:WHR[5]), if a huge chunk of the population is unable to leverage more than they already have. Heck, even automakers like Ford (NYSE:F[6]) and Toyota (NYSE:TM[7]) could struggle to sell cars and approve financing for the up-and-coming generation now and down the line.

Another potential headwind is that student loans are one of the only pieces of post-grads’ credit histories. The impact of missed payments is thus outsized, the same way a hit to a stock is greater felt in a less-diversified investment portfolio — and could be felt even far down the line.

Defaulting, as I’m sure you know, has a lifelong effect on a borrower’s credit score and can also impact employment.

For the cherry on top, the ripples from the growing number of federally issued loans specifically extend far beyond the loan-holders. With the shift toward federal lending, student loans have also become also the largest item on Uncle Sam’s balance sheet, meaning that taxpayers will be the ones responsible for any losses … losses that are becoming more and more likely.

All in all, the slowly climbing amount of subprime debt sure isn’t a pretty picture … and the potential downside is far more than what meets the eye.

As of this writing, Alyssa Oursler did not own a position in any of the aforementioned securities.

Endnotes:
  1. four simple steps: http://investorplace.com/2012/12/4-rules-for-grads-swimming-in-student-debt/
  2. recently ran an article: http://online.wsj.com/article/SB10001424127887323701904578273711404133732.html
  3. As I mentioned in a previous article: http://investorplace.com/2012/12/the-specter-of-student-debt-is-bigger-than-you-think/view-all/
  4. TOL: http://studio-5.financialcontent.com/investplace/quote?Symbol=TOL
  5. WHR: http://studio-5.financialcontent.com/investplace/quote?Symbol=WHR
  6. F: http://studio-5.financialcontent.com/investplace/quote?Symbol=F
  7. TM: http://studio-5.financialcontent.com/investplace/quote?Symbol=TM

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