How to Develop Effective Rules of Thumb

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1 How to Develop Effective Rules of Thumb Mark Kantrowitz Senior VP and Publisher Edvisors.com Copyright Edvisors Network, Inc. (

2 What is a Twisdom? A twisdom is a tweetable wisdom, a short quotable quote that conveys practical advice, such as an actionable rule of thumb. 2

3 Example Twisdoms Live like a student while you are in school, so you don t have to live like a student after you graduate. Student loan debt is like cooking a lobster. By the time you notice the water is boiling, you are already cooked. If you default on a home equity loan or line of credit, you can lose your home; if you default on a student loan, the lender cannot repossess your education. Cosigning a student loan may be hazardous to your wealth. 3

4 What is an Effec;ve Twisdom? An effective twisdom influences consumer behavior 4

5 Characteris;cs of Effec;ve Twisdoms Simple Easy to learn, easy to remember and easy to apply Communicate a single, well-defined concept Short and concise Actionable Can be personalized to a consumer s specific circumstances Can involve simple comparisons, but do not require complicated calculations Not necessarily optimal or perfect. Rather, they are good enough approximations that trade accuracy and precision for ease of use 5

6 Impact of Effec;ve Twisdoms Improve Decision-Making Help the consumer make decisions and reach conclusions Help people make decisions quickly and efficiently with minimal information Cause Consumers to Act Designed to cause consumers to take a specific action Twisdoms Go Viral Other people start adopting the twisdom as their own 6

7 Top Twenty Twisdoms Savings and Scholarships 1. It is cheaper to save than to borrow. 2. Every dollar you save or win is about a dollar less you ll have to borrow. 3. Save a fifth of your income for the last fifth of your life. 4. College costs triple in the 17 years from birth to college enrollment. 5. You can t get any aid if you don t apply. 6. If you have to pay money to get money, it is probably a scam. FAFSA 7. File the FAFSA as soon as possible after January 1. Do not wait for tax returns to be completed or for college admissions decisions. 8. Students who file the FAFSA in January, February and March receive more than double the grants, on average, of students who file the FAFSA later. 7

8 Top Twenty Twisdoms Loans (Borrowing) 9. Live like a student while you are in school, so you don t have to live like a student after you graduate. 10. Every dollar you borrow will cost about two dollars by the time you repay the debt. 11. Education debt may be good debt because it is an investment in the student's future, but too much of a good thing can hurt you. 12. Budget before you borrow. 13. Keep debt in sync with income. Total student loan debt at graduation should be less than the borrower s annual starting salary, and, ideally, a lot less. 14. Borrow federal first, as federal student loans are cheaper, more available and have better repayment terms than private student loans. 15. A cosigner is a co-borrower, equally obligated to repay the debt. 8

9 Top Twenty Twisdoms Student Employment 16. Students who work 40 or more hours a week during the academic year are half as likely to graduate as students who work 12 hours or less a week. Loans (Repayment) 17. Monthly loan payments on a 10-year term are approximately 1% of the amount borrowed. 18. Choose the repayment plan with the highest monthly payment you can afford, to save the most money over the life of the loan. 19. Accelerate repayment of the loan with the highest interest rate to save the most money by reducing the average interest rate on the borrower s loans. 20. Students who drop out of college are four times more likely to default than students who graduate from college. 9

10 Developing Effec;ve Twisdoms Hindsight is 20/20 Although twisdoms seem simple in hindsight, a matter of common sense, they often require a lot of effort and careful analysis to develop. Example: Total student loan debt at graduation less than annual starting salary This twisdom seems obvious because it links debt to income But the derivation of this twisdom took a twisted path toward defining affordable debt 10

11 What is Affordable Debt? For decades, advice was based on debt-service-to-income ratios Monthly student loan debt payments should be less than 10 percent of gross monthly income Stretch limit of 15 percent of gross monthly income Similar to credit underwriting criteria used by mortgage lenders, which cap the percentage of income that can be used to repay a mortgage This is too complicated in practice for most borrowers Difficult to calculate monthly loan payments and percentages of income Loan amortization calculations involve solving nonlinear equations Calculating percentages of income requires long division Requiring the use of an external tool, such as a special-purpose calculator, makes a rule of thumb less effective, because the rule is less immediate in impact 11

12 Second Try: Find a Workaround Workaround Develop additional rules of thumb for each component of the rule of thumb The monthly payment on a student loan is about one percent of the original loan balance, assuming a 10-year repayment term So, to calculate the monthly payment, remove the two least significant digits from the amount borrowed Problem Adding more steps increases the complexity of the rule of thumb, reducing the likelihood that the consumer will rely on the rule of thumb Ideally, a rule of thumb should be self-contained, without requiring additional steps or insights for implementation 12

13 Third Try: KISS Principle KISS = Keep It Simple, Stupid Use information that is readily available to the consumer, such as amount of debt and annual income Translate the rule of thumb concerning debt-service-to-income ratios into one involving the amount of debt and annual income Start with the complicated analysis and try to simplify it 13

14 Start with the Math P=B (1+ R/12 ) 12N / (1+ R/12 ) 12N 1 R/12 B = Total Loan Balance N = Repayment Term in Years R = Annual Interest Rate P = Monthly Payment 14

15 Approximate the Equa;on? Use the first few terms of an expansion of the exponentiation as an approximation, such as P=B(R+ 1/N )/12 or P=B( R/2 + 1/N )/12 The latter yields an approximation for the total payments over the life of a loan as about equal to B+ B R/2 N. But this doesn t help us evaluate affordable debt. 15

16 Recast into Debt- to- Income Ra;o Use the original equation to recast the debt-service-to-income ratios into a simpler debt-to-income ratio Requires certain assumptions A reasonable amount of student loan debt is debt that can be repaid in 10 years or less. The interest rate on a student loan will be between 4% and 9%. The monthly loan payment is affordable if it is less than 10% to 15% of the monthly adjusted gross income (AGI). 16

17 Evaluate the Extrema Evaluating the amortization equation on the extrema yields a range that contains the actual values Extrema #1: Interest rate is 4% Monthly loan payment is 1.01% of the loan balance For monthly payment to be affordable, loan balance must be between 82% and 123% of annual AGI Extrema #2: Interest rate is 9% Monthly loan payment is 1.27% of the loan balance For monthly payment to be affordable, loan balance must be between 66% and 99% of annual AGI Pick a round number that is close to the ranges for each extrema, namely 100% à Total student loan debt less than annual income 17

18 Validate Rule of Thumb Validate the rule of thumb by running the calculations in reverse If debt-to-income ratio is 100%, the debt-service-to-income ratio is 12.1% for an interest rate of 4% and 15.2% for an interest rate of 9% Validate the rule of thumb by using it on empirical data For the historical average interest rate of 6.8%, the debt-service-toincome ratio is 13.8% when the debt-to-income ratio is 100% 18

19 Rule of 72, 120, 144 Rule of 72 calculates how long it will take an investment to double in value with annual compounding of interest Divide 72 by the interest rate Similar rules of thumb Triple an investment à Rule of 120 Quadruple an investment à Rule of 144 Quintuple an investment à Rule of 160 or 168 Doubling time with daily compounding yields the Rule of 69 instead of the Rule of 72 Rule of 70 calculates how long it will take inflation to cause the value of an investment to drop in half Divide 70 by the inflation rate 19

20 Deriva;on of Rule of 72, 120, 144 R = Return on investment N = Number of years M = Multiple increase in investment value M=(1+ R/100 ) N Take logarithm and solve for N x R: N R= R/ log (1+ R 100 ) log M Expand exponentiation, approximate and solve quadratic equation for N x R: N R=100 ( (2M 1) 1) 20

21 Thank You! Mark Kantrowitz Publisher, Edvisors.com Follow on Free Guide to Filing the FAFSA A PDF version of the book, Filing the FAFSA, is available for free download at book Also sold in paperback format on Amazon.com for less than $10 21

Student Loans. Student Worksheet

Student Loans. Student Worksheet Student Loans Student Worksheet Name: Part I: If help from parents, scholarships, grants and work study do not cover the full cost of a student s education, many students get to loans to pay for school.