Should You Use Student Loan Funds and Financial Aid to Invest in Stocks?

When student loan funds and financial aid leave you with an excess of money, you might get the idea to invest it.

Is that even legal?

No, you're not breaking any laws if you use student loans or financial aid to invest.

But does that mean you should?

There are arguments in favor of investing excess student loan proceeds, and several against it.

But, generally, the risks are greater -- particularly when you consider the short time horizon you'll have to invest.

Rules for Using Student Loans

The rules for using student loans for purposes unrelated education – particularly one like investing in stocks – are something of a gray area.

While there is no specific prohibition on investing with the funds, there are rules for how the funds are used.

The specifics will depend on whether your loan is federal or private.

Federal student loan rules and laws

According to U.S. Department of Education website, Federal Student Aid, federal student loans may be used for the following purposes:

"You may use the money you receive only to pay for education expenses at the school that awarded you the loan.

Education expenses include such school charges as tuition, room and board, fees, books, supplies, equipment, dependent child care expenses, transportation, and rental or purchase of a personal computer.

Talk to someone at the financial aid office at your school if you need more details."

And we can see from this description:

The intended purpose of federal student loan proceeds is precisely targeted to school-related expenses.

Though there may be some wiggle room if the loan amounts exceed the actual expenses, there may be some risks associated with using the funds for purposes such as investing in stocks.

The website doesn't go into detail in this regard, but the potential should not be completely ignored.

If the particular federal loan you have carries a subsidized interest rate, it may be possible the rate will be increased to an unsubsidized level upon discovery of your investment activity.

Private student loan rules

The rules on use of student loan funds from private sources, like banks, will be determined by the particular institution where you're obtaining financing.

While loan agreements may be fairly standard, specific provisions will vary from one bank to another.

For example, a loan agreement from one bank may be loosely worded, opening the possibility of using funds for investment. Another may be more specific, including a list of prohibitions that may extend to investments and other non-educational uses.

Before you even consider investing with private student loan funds, you must first carefully examine every provision in your loan agreement.

If that agreement includes a specific provision prohibiting investing funds, or even activities loosely related, doing so can invite retribution.

For example, the bank may reserve the right to call in the loan immediately upon discovery of the misuse of funds.

How You May End Up with Excess Borrowed Funds

It can be easier to end up with excess student loan proceeds than you think.

You apply to borrow a certain amount of money, based on published costs associated with your college of attendance.

But those expenses can end up being lower than anticipated (with an equal chance of them being higher).

But if they are lower, you'll find yourself with excess funds.

One of the most common ways this happens is with at-school living expenses. While tuition and fees may be easier to estimate precisely, room and board can vary.

For example, you might forgo a standard meal plan in favor of working out your own meal solutions. You may even find savings by purchasing used books over new ones. And there's always the possibility of additional funds coming in from scholarships.

If you find yourself with unused loan proceeds, it will naturally provide you with greater budget flexibility. That can include investing in stocks.

In theory:

You should generally consider returning those funds to the lender, whether for federal or private loans.

This will ultimately reduce the amount of indebtedness after graduation, as well as any accumulation of interest between now and then.

Why You Might Consider Investing with Student Loans

Despite any risks associated with investing student loan proceeds in stocks, there are clear advantages.

Deferred interest until graduation

Federal student loans in particular defer payment of interest until graduation.

This give you unobstructed use of any excess funds while you're still in school. You can invest the money without concern for making repayments.

This option is usually more limited with private student loans, that may require either a partial or full payment of interest during school attendance.

But the basic idea is that you can invest your money during the period of deferral.

"Relatively" low interest rate

Current rates on federal student loans range from 5.05% to 7.6% (private student loan rates can vary more significantly in either direction).

Those may not be as low as rates on mortgages or car loans, but they are a lot lower than credit cards.

If your loan carries an interest rate of 6%, and you can invest in stocks at the historic average return of 10% per year, you'll have a net 4% return on investment each year.

Getting a jump start on investing

It's common knowledge that investing works better the earlier in life you start.

If you can get going before you even graduate from school and land your first full-time job, you'll be ahead of your peers.

If you take $50,000 in student loans, but manage to conserve $2,000 per year for four years, you'll have $8,000 – plus investment earnings – by the time you graduate. It's certainly not a fortune, but it’ll be a solid start on your investment future.

It will also give you the option to prepay some of your student loan debts upon graduation.

Why You Shouldn’t Invest with Student Loan Funds

Despite the potential benefits of investing student loan proceeds, the strategy is not without risk. And they’re substantial.

Poor investment performance

In the last session, we explored the benefit of getting a higher rate of return on your investment than you're paying in interest on your loans.

That's the optimistic outcome.

But it's equally possible you'll earn less.

For example, while paying 6% on your loans, you may only earn 3% on your investing activities.

Losing money on your investments

If you get into investing at a bad time in the market, it's possible you’ll have a negative rate of return on your money.

You may even see the total value of your investment fall by 10%, 20%, or more. That will leave you in a worse position than you would be had you never invested in the first place.

At the extreme, you could end up losing all the money you attempted to invest, either by being overly aggressive or simply by making bad investments.

That would leave you with the worst outcome possible.

Bankruptcy isn't a likely option

Unlike most other kinds of debt, it is very difficult -- nearly impossible -- to discharge student loan debt in bankruptcy.

This arrangement is bad enough if you have a large amount of student loan debt and poor economic prospects upon graduation.

If the debt includes investments that went sour, you'll be forced to honor obligations on money that never provided you with a meaningful benefit.

Put another way:

Even if your investment activities perform poorly, you'll still be obligated to make good on the student loan debt that you used to make investments.

You could jeopardize your schooling

This is an admittedly extreme outcome, but one that’s highly possible nonetheless.

If you become obsessed with investing student loan proceeds, you may find yourself reducing the amount of money used for your education.

That can result in more time at school (requiring additional financing) or foregoing expenses necessary for your education.

What to do with Excess Financial Aid

Are there better uses for excess student loan proceeds and financial aid than investing?

While it is possible you may gain some advantage by investing excess proceeds, the risks involved should make you properly gun shy.

Some alternatives include:

Using the funds for surviving college life

You're going to be in school for at least four years, and you should want to make that as comfortable and productive as possible.

Using funds for investing could reduce the amount available for that purpose. It may even leave you struggling in certain areas of your college life.

Put the excess funds into safe investments

While it may not make sense to hold money in a savings account or CD paying 2% when you're paying 6% on student loans, at least there’s zero chance of losing money.

Meanwhile, you'll be preserving the option to use the money in any way necessary, and at any time.

It can work as an emergency fund for college, which is always a good option to have.

Repay the unused funds

In a real way, this strategy will leave you better prepared for graduation.

If you use less money than you received in loan proceeds, you’ll reduce the amount of student loan indebtedness.

Since you have to begin repaying any outstanding principal, plus interest, once you graduate, your post-college life will be better for returning the funds.

Final Thoughts

If you do have un-used student loan funds, and you’re considering investing them for the future, carefully weigh out the risks.

There are certainly the ones we discussed above.

But there's also the possibility the rules on federal student loans will become more specific and tighten up in the future.

If they do, you can find yourself wrapped up in an unapproved loan use, with no easy way out.

Use student loan proceeds and financial aid for what they are intended. You'll have plenty of time to develop and build your investment portfolio after you graduate.