Paying for College, before during and after going to college.

In an earlier post I talked about whether investing in a college education is still worth it but I only talked a little about how to pay for it. This article is designed more for those who have decided it is a worthwhile investment but are trying to decide how to pay for it.

First you have to decide who is paying for it, the parents or the student, or some combination of the two. Everyone’s beliefs differ on how much of this responsibility should fall on the parents and how much of it should fall on the children. The government clearly thinks middle class and above parents should be contributing to the cost of a child’s higher education as all financial aid is based in large part on the parent’s income and net worth. Some parents feel they have no obligation, while others feel 100% responsible regardless of whether they can afford it or not. Regardless of your personal feelings and ability to contribute to your child’s education it is important that you are honest with yourself and them exactly how much, if at all, you will be able to help them. It is important you have that discussion as early as possible but certainly several years before the first tuition bill is do. I will discuss this in more detail in an upcoming post on educating your children about money.

For most people a college education will be the second largest investment in their lifetime next to buying a house. For many who get it wrong it will be there largest investment because if they do it wrong or pay more than they can afford, they may never be able to buy on house or will only be able to buy house that is worth less than what they spent on their college education.

Most people (at least those that are financially savvy and secure) set a budget for large purchase such as a house or a car before they start looking. They know what they can afford, and don’t waste time looking at the Maserati or Mansion they cannot afford and don’t really need. Unfortunately, when it comes to a college education, many people fail to see it as a purchase or investment and go about it backwards. They start by looking for their dream school and then scramble and try to figure out how to pay for it. We have made financing a college education so easy, which is good on the one hand because it allows more people to go to college, but because it requires self-discipline which a lot of people lack, it is dangerous on the other hand. It leads to over borrowing causing the current student loan crisis with people buying more education than they can afford or need. You do not want you or your children to be one of the millions of people currently saddled with large debt for the rest of their lives. You also don’t want to be someone with no retirement savings because you spent all your money on your children’s college education or paying off student loans. You need to be honest with yourselves and your children about what you can afford especially if you are using student loans to pay for the bill.

We will talk about student loans in more detail a little later on, but let’s talk about the saving before college starts. This is the ideal situation and one I am hoping all my young readers will take to heart if or when they have children. For parents that want to take on the responsibility of paying for college, either in whole or in part, it is best if you start saving for that expense from the time the children are born. This is a large purchase, think about all the other large purchases you made in your life and how you saved for them. The earlier you start the easier it is, small chunks of money over time is easier to handle then coming up with $100,000 in a four year time frame. More importantly, as I talk about in many of my articles, you will be letting your money work for you. If invested properly any money you put in when your child is one should be worth four times what you put in by the time the last tuition bill in due.

If you manage to save $1,000 a year, and invest it, you should have over $25,000 (the average cost going away one year to a state four year college) by the time your child reaches 18.  You will have more than two years paid for at a two year college or a commuter college if you don’t have to pay for room and board. For some people $1,000 seems like a lot, but broken down that is less than $20.00 a week or a coffee a day. If you are expecting your children to pay in full or part for their college education you can increase how fast the fund grows by teaching them to contribute a portion the money they receive for birthdays or Holidays to the fund. The more you save early on the less burden and fewer loans you or the student will have to take out once they start college.

Starting to save early also gives you some tax advantages if you set up plan such as a 529 plan or Coverdell education account. In either of those accounts all the investment income grows tax free as long as it is eventually used for a qualified education expense. Some 592 plans also allow you to deduct any contributions from you income that is subject to state income taxes. In addition prepaid 529 plans lock in the cost in the year in which you fund them so you don’t have to worry about inflation. Make sure you read all the plan rules carefully if you pursue that option.

So for those of you who are getting ready to go to college or send a child to college, that did not save enough, let’s talk about ways of funding that education. You should apply for all the financial aid and scholarships available to you, but rarely is that enough to pay all the bills. After that, ideally you want to pay all the bills as you go if you have enough income whether that be the student’s part time jobs, the parent’s income or a combination of the two. For those with a combination of high enough income and savings this is the best route. Unfortunately now days, that is more the exception than the rule.

If you cannot pay as you go you need to consider “financing” your education. It is important to understand what you are signing onto when you take out loans to pay for your education, and how expensive that is. The best loans are Direct Student loans offered by the government. The current interest rate is 5.05%, and they tend to have better repayment options. If you demonstrate financial need (financial aid) you may qualify for a subsidized student loan. A subsidized loan means the government pays the interest on the loan while you are in school and a six month grace period after you leave school. There are also unsubsidized direct loans from the government that are not needs based. With these loans you are responsible for all the interest from the date the loan is issued, so your balance grows while you are in college. The limits on these loans for undergraduate work is $31,000 no more than $23,000 may be subsidized. As you can see this falls far short of the $100,000 needed to go away to a public university. If you have no savings and are unable to “pay as you go” you need to come up with another $69,000. If you have to borrow more than the amount you can get from the federal student loans, you will need to seek private student loans. Like with any loan, you should shop multiple companies and pick the one that works best for you. These loans will be based on your credit history and other factors, while they currently advertise rates from 4.99% to 11.99% I have never seen anyone get the teaser low end rates, and even those with the best credit usually end up getting rates of 6% or higher.

Be careful not to borrow too much money! If you have to borrow more than you expect to earn annually once you have your degree you will have a very difficult time ever paying off your debt.  If that is the case you should consider cheaper ways of getting your education, or taking longer to get you degree so you can pay more as you go. I am often asked where I come up with the one times salary number but it is simple math which I explain below. It is true that the higher your expected salary the more wiggle room you have to go above that one times salary number as you will have more disposable income.  Unfortunately the lower your expected salary the converse is true as that means a higher percentage of your salary will be needed just to keep a roof over your head and food on the table. If you don’t know what rent cost for a type or place you are willing to live in, and how much food cost and utilities cost you should check these out now before taking out loans unless you are moving back in with Mom and Dad after college. If your plan to have your own place when you graduate you really need to stick to the loan ratio of 1 times expected Salary if your expected starting salary is likely to be $60,000 or less.

A quick example of what this might look like in real life. For ease of math let’s say you can reasonably expect a starting salary of $50,000 once you get a degree. This math is all about percentages so it works for whatever that number is, just be realistic about how much money you are likely to make in your chosen profession. I am also assuming graduation in four years although most people take longer, which makes the starting balance even higher.

If you borrow $50,000 in four installments starting from first year of college at an average interest rate of 7%, by the time you graduate your balance will have already grown to $58,750. If you amortize (spread it out into equal monthly payments of interest and principal) over 10 years you will have to pay $682.14 a month or $8,185.68 a year.  This would be more than 16% of you annual salary. After taxes and paying off you student loan you would have approximately $33,000 a year to live on. This is doable but would probably mean not much left over for savings, or putting toward a down payment on a house for those ten years, and probably not as much coffee, beer and pizza as you would like. Still probably worth the investment if it leads to a meaningful degree.  For the record you would have paid a total of $81,895 meaning that loan of $50,000 cost you another $31,895 in interest.

Now let’s suppose you borrowed twice you’re starting salary or $100,000. By the time you graduate you are looking at a balance of $117,500 (the cost of a starter home) by the time you start paying off the loans. Again I am assuming a 7% interest rate, but the more you borrow the higher your average interest rate is likely to be. You are looking at payments of $1,364.27 a month which is 33% of your income, after taxes leaving you with under $25,000 a year to spend on everything else for ten years. That is assuming you don’t fall behind on those payments incurring hefty fees and late charges because you are stretched too thin. In addition to paying back the $100,000 you borrowed you will pay almost $64,000 in interest.  Most people that carry these large debt to income ratios end up defaulting, hurting their credit and racking up extra fees ballooning the balance to two and three times what they borrowed. As student loans cannot be dismissed in bankruptcy it set’s them up for a life time of financial instability that is almost impossible to escape from. There are a number of articles on the student loan crisis, and if it sounds like I am trying to scare you, I am. Please google and read a couple of these articles before considering how far in debt you are willing to go for your college education.

Not understanding how costly these loans are has led to our current student loan crisis. Don’t become another statistic, make sure you only borrow what you can realistically expect to pay off. If you are paying for college in part with loans make them as small as possible, cut out any expenses you can and realize you are essentially paying interest on every extra coffee, beer or pizza you get while in college. Student loan debt cannot be forgiven in bankruptcy, and the few forgiveness programs they have are very ineffective and hugely unsuccessful.  If you get yourself in trouble with student loans don’t count on the government bailing you out.

Now you’re out of college working a full time job, and you’re wondering how to prioritize paying off your student loans, with your savings and a goal of buying a house. I talk about this in more detail in my post Setting Priorities for your Savings and Financial plan but the quick answer is make sure you pay at least your minimum balance on time each month to avoid penalties and taking a hit to your credit score. After that your goal should be to save at least 20% of your salary each month, paying off debt can go toward that savings goal. Where to put that savings depends on rates of return, the best rate of return is almost always going to be any employer match to your 401K, so you want to make sure you max that out each month and get the full match. After that you want to pay off your highest interest loans first, which are usually credit cards, followed by student loans. A lot of people like to spread the extra principle payment around or pay off the smallest loan first just so they have one less loan. But you should look at the loan interest as a “rate of return” you are paying yourself every time you pay down the principle. So you should “get paid the most you can” which you accomplish by putting all the extra money towards the highest interest loan you have. As far as buying a house, in most cases this is something that should be put off until your student debt payments fall to below 10% of your salary and you are able to put 20% down on the purchase of a house. Your house payment and student loan payments combined should never exceed 33% of your salary.

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