When you think about buying a car, you think about what you can afford and then buy the best car that falls into your price range. As much as the thought of driving a Maserati or a Bentley makes your heart beat faster, chances are you don’t think it’s worth taking out a second mortgage to own one. So, unless you’ve been saving for years for the car of your dreams, you’ve got to narrow your choices and think more along the lines of a Toyota or a Ford (NYSE:F).
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Parents and students should apply this same decision-making process when choosing a college.
It’s too easy to fall into the trap of assuming that a more expensive school automatically equates to a “better” one-- and then making sacrifices that may not be worth the larger price and incremental value.
In most cases, the average cost for private school is twice that of a state school. Are all private schools twice as good as state ones? Of course not. The private school you’re considering may only be slightly better -- if at all. If ‘Car B’ were slightly better than ‘Car A’, you wouldn’t be willing to pay twice as much for it. You’d make a value judgment. Do the same with college.
Whether you have many years before the first tuition bills come due or enrollment is just around the corner, you’ll have to make a choice based on affordability, factoring in savings, income, and debt. Of course, the more money you have at your disposal, the greater your range of affordable choices.
To maximize those choices, you should start saving as early as possible.
Saving can cut your costs in half compared to borrowing. To cover $40,000 of college costs, you can pay $32,000 by saving $110 monthly for 18 years in a 529- account, assuming a 6% average annual return minus 0.85% in annual fees. Or, you could pay $61,000 by paying 8% interest on a $40,000 loan over 10 years. (Inflation has been factored in to both sets of calculations.) Additionally, the contributions to a 529-account might also have been eligible for income tax deductions based on state tax benefits, which vary state by state. (Please note that a 529 plan’s disclosure document includes investment objectives, risks, fees, expenses, and other information that you should read and consider carefully before investing.)
Another way to look at it is you will be out-of-pocket $110 a month (again, adjusted for inflation) by saving in the 529, vs. spending six times as much -- $670 -- a month to service that $40,000 in debt. Are you certain that in 20 years your income will be six times what it is now? Are you certain that there won’t be other things you will want to spend your money on then?
You’re probably uttering “financial aid” as a mantra to soothe the anxiety that goes with thinking about paying for college. Don’t get too relaxed. There is an expected family contribution (EFC) that you’ll have to pony up -- roughly 30% of your income at that time you apply for aid -- before a school will give you any need-based financial aid. The average EFC is $10,000.
Where is that $10,000 going to come from? If you have a long time horizon, hopefully I’ve convinced you to start saving now. If you don’t have a long time horizon, and your savings are limited, your options are, too. You can adjust your lifestyle, you can borrow money, or do some combination of the two. Regardless, you’ve got to cover that nut for the EFC. So maybe it’s wise to think about a school that is a more affordable option.
And then there are the costs above the EFC. Let’s say your EFC is $10,000. And you’re looking at a school that cost $15,000 a year, and one that costs $30,000. (Remember, the average price for a private university is two times the cost of a public one.) You’re looking at an additional $5,000 vs. $20,000. So, you’re back to thinking of financial aid as the answer. Most financial aid is in the form of loans, not scholarships or grants.
There are education loans, but that can lead to debt for both you and your child. Is the school that will cost the most truly worth it? It may be. But bear in mind once an education loan is taken out, you’re stuck with it under all but the most extraordinary circumstances. These loans can’t be discharged through a bankruptcy filing, for example. Wages will be garnished, and even Social Security can be tapped until education loans are paid back.
Other kinds of debt -- second mortgages, lines of credit, personal loans, credit card debt -- bring their own burdens, as any kind of borrowing does. If you have to borrow heavily -- regardless of the source of the money -- to meet college costs, you may be “shopping” for a college that is outside your range of affordability.
Understandably, you want to your child to have the educational equivalent of a Rolls-Royce. And the more savings you have, the more likely it is you can give your child that option. You need to think about what are you willing to sacrifice now and what would you be willing to give up in the future to make that possible.
Making a common-sense, value-oriented decision about what you can afford is a valuable lesson for your child, wherever he or she ends up going to school.