Some college students may have excess student loan funds and consider investing them instead of using them for education-related expenses. While this practice is not explicitly illegal, it falls into a legal gray area, especially when federal student loans are involved.
Federal student loans, particularly those subsidized by the U.S. Department of Education, have specific restrictions that limit their use to qualified educational expenses. Borrowers who misuse these funds, even if not breaking the law outright, could face consequences such as repaying subsidized interest or other penalties. Private student loans, on the other hand, typically have fewer restrictions, making it less risky to invest those funds.
Despite the legal uncertainties, the bigger concern for student investors is whether they can generate a sufficient return before repayment begins after graduation. With student loan interest rates ranging from 6.53% to 9.08%, achieving consistent investment returns high enough to justify the risk can be challenging.
Federal vs. private student loans: what you need to know
One of the most critical factors in determining whether investing in student loans is feasible is the type of loan borrowed. Federal loans generally have lower interest rates, offer income-driven repayment plans, and may provide loan forgiveness options. However, they also come with strict guidelines about how funds should be used.
Federal student loans are granted based on financial need and are meant to cover tuition, housing, books, and other education-related expenses. The government subsidizes the interest on certain federal loans, making it risky to invest those funds instead of using them for their intended purpose. If discovered, borrowers may be required to repay the interest that the government covered while they were in school.
Private student loans, offered by banks and other financial institutions, have fewer restrictions on how the funds are used. However, they often come with higher interest rates and fewer borrower protections. Since private lenders do not subsidize interest, investing these funds is less likely to result in penalties. That said, the challenge remains: Can students generate a return high enough to offset the cost of borrowing?
Should you invest your student loan funds?
Historically, the stock market has provided long-term returns averaging around 10% per year, making investing seem like a potentially profitable move. However, markets are unpredictable, and there is no guarantee that investments will generate the returns needed to cover loan interest and principal repayments.
Consider the case of Chris Sacca, a former college student who successfully turned his student loan money into a multimillion-dollar investment portfolio between 1998 and 2000. While his story is exceptional, it has encouraged other students to take similar risks—though not all with the same success. For every success story, many others lose money and are left with mounting student debt to repay.
Scott Snider, a Certified Financial Planner (CPF®) and Chartered Retirement Planning Counselor (CRPC®) from Mercer Advisors, warns that investing student loan funds is generally not advisable. He points out that with student loan interest rates ranging between 6.53% and 9.08%, the risk-reward tradeoff is often not in favor of the borrower. If a student were to invest right before a recession, they could suffer losses while still being responsible for repaying their loan in full. Instead of investing loan money, he suggests focusing on paying down debt first and using other savings for investment purposes.
Alternatives to investing excess student loan money
If students find themselves with excess loan funds after covering tuition, books, and other necessary expenses, there are better options than investing in the stock market:
- Return the excess funds: Students can return any unneeded loan funds to the lender, reducing the amount borrowed and the interest accrued.
- Use for essential living expenses: Federal student loans allow funds to be used for reasonable living expenses such as rent, groceries, utilities, and transportation.
- Save for future educational costs: If a student anticipates higher expenses in upcoming semesters, they can set aside the excess funds to use when needed, reducing reliance on additional borrowing.
- Start an emergency fund: Keeping extra money in a savings account as a financial cushion can be a safer and more reliable way to ensure stability during college.
