Savings or student loans: does it pay to save for college?
For parents with young children, the two most common questions we are asked are:
- Is it worthwhile to save for college?
- If I do, am I penalized for saving?
The short answer to the first question is yes. The main reason the answer is yes is that saving beats borrowing every time. Financially speaking, it is always better to have interest paid to you (when you save) rather than to pay interest to someone else (when you borrow).
Here is an example:
The Smith family are savers. They begin to save for college when their son Tom is five years old. They put aside $175 each month ($2,100 per year). After 13 years they will have contributed $27,300. If their return is 5% per year, by the time Tom is ready for college at age 18, they will have accumulated $40,000.
The Jones family did not save. As their daughter Jane is about to start her freshman year, the Jones’ look at how much of their current income they can use to pay Jane’s college costs and decide they need to borrow $10,000 per year, or $40,000 total. The interest rate is 6.8% with a 10-year repayment period. After Jane graduates, she gets a repayment schedule from her lender. Her total obligation, repaying both the principal and the interest, comes to $55,238.
Borrowing: $40,000 = $55,238.
Given this comparison, it is obvious that the Smith family made the wiser financial decision. For the same $40,000, they paid $27,300, while the Jones’ paid more than $55,000.
While saving for college by itself is a good idea (provided you don’t do it at the expense of maintaining your normal living standards, putting aside money for emergencies and having an adequate retirement plan), even apart from the loan comparison – remember, the $27,300 still turns into $40,000 – it is reasonable to contrast saving with borrowing because loans (both student and parent) are one of the primary means of paying for college in today’s world.
In 2005-2006, post-secondary students received a total of $134.8 billion in student aid from federal and state governments, colleges and universities, and other private sources, according to the College Board. More than 900,000 loans were made to parents (what are called PLUS loans), and private loans totaled $17.3 billion in the 2005-2006 school year, also reported by the College Board.
Let’s assume that based on the above, you buy into the idea that setting aside an affordable amount each year makes sense. (By the way, it is a good idea to start when your child is born, but you should at least begin by age 8 so you have 10 years of contributions and interest accumulation.)
However, we are not done yet. Let’s say you take our advice, and over time, you set aside a reasonable amount of money in a 529 plan, say $50,000 in current dollars. Based on the cost of college when your child enrolls as a freshman, let’s also say that this amount is not enough to pay the full costs, and it is necessary for you to apply for aid.
When that happens, to what extent are you “penalized” for having this amount? If the $50,000 in the 529 plan is your total savings, nearly all of it will be protected from the calculation a school will make about how much a family needs to contribute. The “need formula,” as it’s called, is the total cost of attendance less the amount your family can contribute. The difference is the financial need upon which aid is based. The formula has an asset-protection allowance so that the first $50,000 worth of savings in a 529 will not affect your aid eligibility at all.
But, let’s assume you have an additional $50,000 in savings and investments that “uses up” the protection allowance. If this is the case, the $50,000 in the 529 plan is subject to full force of the need formula. This $50,000 asset will increase your expected family contribution by about $2,500. But if we assume that you don’t pay this $2,500 until well into the academic year, what has happened? Using a 5% return on your college savings, you will have made nearly the entire $2,500 in interest.
The bottom line is that the need formula will ask you to give anywhere from zero to an amount that you will cover, or nearly cover, from the return on your college savings. And in the end, that doesn’t seem like such a “penalty” for saving.
Saving for College
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- When should I start planning for college funding?