Student loans are distributed for the purpose of covering educational costs for attending college, and they come from both government and private lending organizations. In some cases, students who find themselves with excess money during college choose to invest student loans rather than returning them to the government. While this type of investment is not strictly illegal, it raises numerous ethical issues that result in a legal and moral gray area for aspiring student investors.

Key Takeaways

  • Investing student loan money is not illegal.
  • However, such investing does fall in a legal and moral gray area.
  • Borrowers of government-subsidized loans could face legal action if they invest the money, which may include repaying subsidized interest.
  • Private student loans have fewer restrictions and students likely won't face any recourse for investing that money.
  • A bigger risk, however, might be the inability to generate sufficient return before repayment is due after graduation.

Between 1998 and 2000, a college student and inexperienced investor Chris Sacca used his student loans to generate an investment portfolio of more than $12 million, according to Inc.com. Sacca is an extreme example of the growing trend of college students who choose to divert money intended for educational expenses and attempt to generate a return in the stock market. Such a move is risky, but it’s not without its benefits, as wise investments can generate revenue that exceeds the interest on private and federal loans.

Investing Federal Government Student Loans

The biggest legal consideration when investing student loans is whether the loans are from a private lender or a U.S. Department of Education contracted lender. The Department of Education generally has more strict rules about accepted uses of student loan funds, while private lenders often trade higher interest rates for fewer restrictions.

One of the biggest differences between federal student loans and private loans is that the government subsidizes interest on some student loans as an investment in an educated population. Students who spend their federal loan money on noneducational expenses may not be breaking the law, but they could face legal action from the DOE if their actions are discovered. In some cases, this may include repaying subsidized interest.

Student Loan Amounts

The amount of student loans each student receives is based on a relatively complex formula that takes into account dependent status, parental income, yearly income, residency status and whether the student will be attending full- or part-time. The final figure is known as the cost of attendance, and it generally includes a living allowance for students who are living off-campus.

The living allowance is where the gray area of student loan use begins, as some students choose to invest student loans in excess of attendance costs in the same way that others choose to use them for unrelated living expenses. In cases where institutional scholarships cover the cost of tuition and room and board, students may find themselves with thousands of dollars in unused student loan money to return or invest.

Students who wish to invest student loans while incurring as little risk of legal action as possible should avoid investing government-subsidized loans. Investing the full amount of refunded student loans is also a risky move, and more conservative investors choose to stick to the excess amount allotted for general living expenses. While litigation is a possible risk, the real risk most student loan investors face is not being able to make a return on their investment before payments come due after graduation.

The Advisor Insight

Scott Snider, CPF®, CRPC®
Mellen Money Management LLC, Jacksonville, FL

While not strictly illegal, investing your student loan proceeds means you must beat the interest rate charged on your loan to reap any meaningful benefits. With current loan rates at 5.05% to 7.60%, the range is incredibly wide, while the historical average return of the S&P 500 dating back to 1928 is 10%. Therefore, the risk-reward tradeoff for investing the money of any loans that charge 5% or more is not enough to justify the downside potential. This risk is especially pronounced if you invest the money right before the start of a recession, which could potentially cost you the entire capital plus more. For loans that charge lower interest rates, it is advisable to focus on paying down the debt and then invest other savings instead.