Student Debt Hampers Small Business Growth

Brendan Harkness

Brendan Harkness | News

Jul 10, 2014

It sounds like a perfect storm: rising tuition costs for higher education combined with a recession-weakened economy and a lack of employment can only mean an epic disaster for recent college grads, right? Some say yes, and others say no.

This question has recently become more pertinent than ever, with the enactment on July 1st of new legislation that governs the terms of federal student loans. Student loan rates for new loans will now be based on the financial markets, and could go up each year. Interest rates are currently capped at 8.25% for undergraduates, 9.5% for graduate students, and 10.5% for parents taking out Plus loans.

Are these new terms going to make things even more difficult for debt-ridden grads, and force taxpayers to shoulder the extra burden? A pair of recent studies investigated the issue, examining the amount of debt graduates face today and how they are dealing with it.

Student Loans Not A New Tragedy?

In a report published by the Brookings Institute, Beth Akers and Matthew Chingos studied the education debt levels and incomes of young households from 1989 to 2010. They concluded that there is no new student debt problem, and that sensationalist media stories have overblown some exceptional cases, painting an inaccurate picture of the reality. Young entrepreneurs now, they say, have an equal ratio of risk-to-reward of those a generation ago. As you’ll see, however, things aren’t so simple.

The authors have 3 main findings. The first is that about 25% of the increases in student loan debt from 1989 to 2010 have been as a result of more people pursuing higher education, particularly graduate degrees. It’s a good thing, and no cause for alarm.

This can be shown by the increases in debt for people with a graduate degree compared to a bachelor’s. The average debt for a person with a graduate degree went from under $10,000 in 1989 to over $40,000 in 2010, compared to a bachelor’s degree which went from $6,000 to $16,000.

The second major finding is that average incomes for college graduates have increased along with the amount of debt they needed to pay, enough to pay for the increased debt. The third finding is that monthly payments for student loans have stayed the same or decreased, as lenders are offering longer average repayment terms. The average payment-to-income ratio has actually fallen, from 15% to 7%, and median spending on monthly payments has stayed the same from 1992 to 2010, at about 3% to 4% of monthly income.

The authors finish by concluding that students today do not face any new challenges, compared to those a generation ago. However, they do include a caveat at the end, saying that the penalties for failure that young entrepreneurs face are greater than ever before, but that the rewards for success have grown to match:

“… As students take on more debt to go to college, they are taking on more risk … This risk is rewarded for the average borrower with increased earnings, but individuals who make bad or unlucky bets will be farther from financial security than borrowers in the past.”

Entrepreneurship Down Among Young Grads

Many take issue with the conclusions of the previous study, arguing that they are not adequately assessing the impact of a longer loan repayment period. While monthly payments may be down, being faced with decades of student loan bills could be having a significant effect on the willingness of college grads to take risks.

This is just what was found in another study by Brent W. Ambrose of Pennsylvania State University and Larry Cordell and Shuwei Ma of the Federal Reserve Bank of Philadelphia. In a study titled “The Impact of Student Loan Debt on Small Business Formation,” the authors looked at the growth of student debt compared to net small business formation, between 2000 and 2010.

Small businesses, which make up about 99% of all businesses, are more susceptible to changes in an entrepreneur’s personal debt capacity than larger businesses, which tend to have outside sources of funding. The smaller the company, the more likely it is to be influenced by personal student debt. With 23 million small businesses in the United States, providing 55% of all jobs and taking up 30% to 50% of all commercial space, the effects of personal student debt on the economy becomes a crucial dynamic.

The study found that the rise in student debt has had a negative impact on the smallest group of small businesses, which have 1 to 4 employees. These are the companies most damaged by increased personal debt. A rise in personal student debt by the smallest interval studied, for example from 4.7% to 8.45%, was discovered to correspond to a 25% reduction in the growth of businesses with 1 to 4 employees, a major impact.

In addition, the authors found that this trend was consistent in other countries as well: countries with more student debt produced fewer companies of 1 to 4 employees.

Interestingly, an opposite effect was found for consumer debt. The more consumer debt in a particular country, the higher the rates of entrepreneurship. This reinforces the notion that access to personal credit is a boon to business growth and the economy in general.

Student Debt Negatively Affects Some Economic Behaviors

Together, these studies suggest that rising student debts are having a negative impact on entrepreneurship, reducing the funds available to small business owners.

While the first study provides a benign conclusion, it does not study entrepreneurship, nor does it take into account the full spectrum of effects of a lifetime of debt. It only compares rates, without examining career outlooks or the effect that a higher risk-to-reward ratio has on entrepreneurs.

From the second study, we can see that student debt discourages entrepreneurship on the smallest scale, and this trend is consistent across many countries. While larger firms currently seem immune to this problem, the lack of personal financial security among young graduates due to student debt could become a larger problem if it continues, eventually impacting companies with more employees.

These are only two glimpses into the economic situation of college grads, and we are suffering from a real lack of information when it comes to such recent trends.

According to Thomas Berry, a Professor of Finance at DePaul University and long-time student of financial decision making, there isn’t enough data to make any definitive statements about the effects of student debt on young would-be entrepreneurs.  “The number of potential entrepreneurs is very small relative to recent grads,” he said.

The recent economic downturn is also a strong confounding factor when trying to understand how grads are reacting to their loan debts, because everyone is feeling the effects.  “As for risk aversion in general among recent grads there is a marked decline in home buying, but this may be a reaction to the crisis since it is also seen with recent grads with no student debt,” said Berry.

Interested in reading up on financial advice for students? Read our blog posts.

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