It’s presidential election season and many important issues are being discussed. Of course student loans are always a hot topic, as every politician knows that this is the most effective way to appeal to young voters. This blog is not meant for political discussion; however, if I see a way where readers of this blog can learn and benefit from a political issue, I will certainly write about it.
A few weeks ago, career politician Bernie Sanders, took to twitter to express his thoughts on student loan interest rates. Lets take a look at what Mr. Sanders said:
Makes sense right? Your first thought might be that Mr. Sanders makes a valid point. Why should students pay double and triple the interest rates on their loans when (presumably) better off homeowners pay a meager 3%? Seems unfair on the surface, but let’s dig a little deeper.
What Mr. Sanders and his supporters don’t understand is the (substantial) difference between a secured loan and an unsecured loan. When my friend, an avid Bernie Sanders supporter, sent me this screenshot, I asked him if he knew why students were paying a higher interest rate on their loans. He didn’t know why, but he went ahead and told me that he thought it was unfair.
There is a reason for this “injustice”. The reason for this is a student loan is an unsecured loan, while a loan for the purchase of a home is a secured loan. Let’s take a look at the stark difference between the two.
A secured loan is a loan that is issued when the borrower pledges an asset (ie – a house) as collateral for the loan. Should the unfortunate borrower become unable to repay the loan, the lender sells the pledged asset and uses the proceeds to repay the debt.
An unsecured loan is a loan that is given without the borrower pledging any type of asset as collateral to the lender (ie – a student loan). These types of loans are usually based on the borrower’s credit history. Without going into too much legal detail, if a borrower defaults on an unsecured loan, a lender could lose the entire loan balance.
Now put yourself in a lender’s shoes for a second. Would you charge a borrower a higher interest rate if they weren’t able to pledge an asset as collateral? Any sane person would say yes.
Let’s revisit Mr. Sanders’ twitter post. We now know that a student loan is unsecured, and a home loan is secured. Therefore, it makes perfect sense that student loans have a higher interest rate than a mortgage.
Knowing the difference between a secured and unsecured loan will be valuable for your investment education. If one day you would like to be a lender to get a return on your cash savings, be sure to decide if you would like to own secured loans (less risky, lower return) or unsecured loans (higher risk, higher return).
Perhaps Mr. Sanders, busy as he may be, will happen to come across my blog post and finally get the answer to his Tweet.