One of the significant decisions a young adult makes is what they will do once they graduate from high school. For many, the decision is to attend a four-year college. Likewise, many parents envision their child moving on to get a quality education that leads to a good paying job which sets the graduate on a path to financial independence. Years ago, the college decision involved, which colleges or universities accepted a student based upon their grades and test scores. From there, the student would make their choice based upon which school had a good program in their desired field of study, how they felt about their campus visit, and even how competitive a school’s sports teams were. Cost was often a secondary factor.
However, over the past ten to fifteen years, the cost of a college education and figuring out how to pay for the education have become more problematic. U.S. News & World Report has reported that over the past ten years the tuition for private universities has increased an average of 4.1% per year; for public universities the increase is an average of 4.7%. Given these cost increases, student loans have become a more significant element of how a college education is financed, so much so that student loan debt is impacting the financial futures of not only young graduates but also parents as they plan for retirement. A recent statistic indicates that outstanding student debt now stands at over $1.4 trillion and student loans are the second largest type of debt next to mortgage loans. The amount of student debt will likely only continue to increase given the cost of education is increasing at a faster rate than families can save.
So how should a family approach the college selection process and finance the escalating cost of college without creating an insurmountable financial burden during the early part of a student’s working career? A large part of the answer involves taking a prudent and diligent approach to evaluating the cost of a school compared to the amount a family and student can afford. Similar to buying a home, a car, or even choosing where to go on vacation, a family needs to understand the cost of attending a school and determine if that cost is within the family’s budget. Parents and children should sit down at the beginning of the selection process and utilize a school’s net price calculator that will help estimate a family’s out-of-pocket costs. Determining the total amount of family college savings plus potential school grants and scholarships plus a reasonable amount of low-cost loans should approximate a school’s cost of attendance. The key is avoiding an excessive amount of high-cost loans. Taking this approach up front will allow a family to qualify affordable schools and rule out unaffordable choices.
Let’s take a closer look at the three key elements of financing a college education—family savings, grants and scholarships, and college loans.
Family Savings
Family savings needs to be a primary element of funding a college education, and the key to savings is to start early when the child is born, or even before. There are several savings strategies that parents can consider. A 529 Plan is a good savings vehicle to utilize given the flexibility it offers and the tax breaks it provides. The benefits of a 529 Plan include the following:
- Contribution limits to 529 Plans vary by state, with the lowest limit $235,000 and the highest $475,000.
- Thirty-five states offer state tax deductions or tax credits for contributions up to a certain limit. For a married couple filing jointly, both New York and Connecticut offer a state tax deduction up to $10,000 per year. Unfortunately, New Jersey does not provide a state tax benefit. Be sure to note that most states require contributions to their state’s 529 plan to qualify for the tax deduction.
- Contributions can be invested and all earnings are tax free assuming they are ultimately used for qualified education expenses. Be watchful of adviser-sold funds that may have higher up-front and/or annual fees.
- Many state programs offer age-based investment funds that have the feature of reallocating invested funds so that the student has a larger exposure to stocks during younger years and less exposure to stocks as the student approaches college age.
- It is recommended that a parent be the account owner and child be named the beneficiary, as this arrangement is more favorable when the value of a 529 Plan is evaluated in financial aid process. If a child or a grandparent is the owner, the plan assets will be treated less favorably for financial aid.
- Under the new 2017 tax law, the Tax Cuts and Jobs Act (TCJA), a 529 Plan can now be used to fund up to $10,000 of annual tuition for secondary schools.
- Finally, if a child is the beneficiary of a 529 Plan but chooses not to attend school or receives grant and scholarship money such that the 529 Plan funds are not needed, the 529 Plan can be switched to another family member tax free.
As they begin saving for college, parents should be careful to balance the amount they allocate for college savings with the amount they direct to building their retirement savings. Many parents want to be able to provide for a child’s college education, but it is important that parents don’t do so while putting their own retirement plan at risk. A student will have a lifetime of earnings to use to pay off college debt, whereas a parent in their pre-retirement years has very few years to build up adequate retirements savings.
Another savings approach that a parent may consider is contributing money designated for college savings to a Roth IRA. The benefits are as follows:
- the contribution amounts can be withdrawn tax free to pay for education,
- the Roth IRA is a non-countable asset in the financial aid calculation,
- if the child does not end up needing these funds for college, the parent can maintain them for their retirement as the earnings accumulate tax-free.
A downside to the Roth IRA strategy is that there are income thresholds that may limit the ability of a parent to make a Roth contribution.
Grants and Scholarships
A second element of financing a college education is grant and scholarship money. Grants and scholarships may be issued by schools or the federal government using either a needs- or merit-based approach. The FAFSA (Free Application for Federal Student Aid) is used by schools and the federal government to evaluate eligibility for need-based aid. All students should complete a FAFSA each school year. The current FAFSA can be prepared beginning in October for the school year that begins the following September; it is based on the parents’ tax return for the year prior to the October period (i.e., the FAFSA for the 2019/20 school year can be completed beginning in October of 2018 using the 2017 tax return information). Many private schools also require that the CSS Profile be completed; this is more comprehensive than the FAFSA.
Merit-based aid, also a significant portion of the financial aid equation, is often overlooked. Over the last couple of decades, the growth in merit-based aid has significantly outpaced the growth in need-based aid. Merit-based aid is essentially a tuition discount offered to attract certain students to the school. Most merit-based aid is academic, and the lion’s share is given to students who fall in the top quartile in terms of grades and/or test scores. Thus, it is often financially advantageous to consider schools where the student will fall in that top quartile. Other factors that may drive merit aid are students who will add to the diversity to the student population, are strong athletes, or are talented in the performing arts. Another often-overlooked factor is geographic diversity. Many schools are looking to expand their geographic diversity and will be more likely to offer merit aid to a student from an underrepresented part of the country. Bill and I both live in the Northeast, and students from this part of the country who are willing to look at schools in the Midwest, for example, would be more likely to get better merit offers than from schools in the Boston to Washington corridor. Only the very elite institutions (Ivy League schools, Stanford, Williams, etc.) offer no merit aid, but on the flip side those institutions have significant endowments and are very generous in offering need-based aid.
The benefit of school grants and scholarships, of course, is that they do not need to be repaid. Likewise, the Pell Grant is a Federal needs-based program that does not require repayment. Students can also pursue scholarship money by applying to various scholarship programs that may be offered by local organizations and companies. Finally, take advantage of any work-study program funds that a school may offer; work-study allows a student to earn aid by obtaining an eligible job on campus.
Loans
A third way that college costs are funded is through the use of loans. The most favorable student loans are the Federal direct subsidized and unsubsidized loans, also known as Stafford loans. Students are required to complete the FAFSA in order to qualify for Stafford loans. These loans typically have favorable interest rates, although rates have risen given the recent rise in interest rates. For the upcoming 2018/19 school year, the interest rate on these loans is a fixed rate of 5.05%. It is more favorable to receive subsidized loans versus unsubsidized loans. While both loan types carry the same fixed interest rate, the interest on the subsidized loans does not begin accruing until 6 months after graduation, which is when repayment of the loan begins. Interest on unsubsidized loans begins accruing as soon as the loan funds are distributed and repayment begins immediately.
Another Federal loan program is the Parent PLUS loan. These are less favorable loans. Parent PLUS loans have a higher fixed interest rate, 7.6% for the upcoming 2018/19 school year, and interest on these loans begins to accrue immediately, although repayment may be deferred until 6 months after the student graduates. The standard repayment term is 10 years, but in some circumstances this can be extended to as long as 25 years if the total loan debt is over $30,000.
Parents may also consider home equity loans, although the new 2017 TCJA tax law no longer allows a tax deduction for interest paid on a home equity loan used to pay for education, which makes these loans costlier. Loans from cash value life insurance policies can be utilized; if not repaid these reduce the death benefit by the amount of the loan if the insured dies before the loan is repaid.
Finally, there are private loans, which should be considered as a last resort. These loans are issued by banks and other educational funding organizations. These loans typically carry very high interest rates, although at times an organization may offer interest rates that are comparable to Stafford loan rates. Most of these loans accrue interest while the student is in school. It is important to understand the specific borrower protections that a private loan may provide as often these terms are less favorable than those offered by Federal loans.
Funding four years of undergraduate education can be daunting; however, the real challenge for students and parents may come when they need to find the means to repay the portion of education costs that were funded with loans. Assuming graduates are fortunate enough to start a job in their chosen field, it is imperative that they gain an understanding of their loan repayment plans and budget their finances to be able to make the required repayments. If their monthly cash flow position offers any discretionary savings, they might want to consider making additional payments against the loan balances. For example, paying off a loan carrying a 5–8% interest rate compares favorable to the opportunity cost of having the money in a low interest-bearing savings account.
Over the years, as student loan balances have risen, several repayment programs have been developed that may be worth considering. For Federal loans, there are two types of repayment options: balance-based plans where level or graduated payments are made over 10–30 years and income-driven repayment plans, which offer a tailored monthly payment using a formula tied to a borrower’s income. In some instances income-driven repayment plans may be designed to foregive the loan balance after 20–25 repayment years. It is important to keep in mind is that any loan balance that is foregiven will be a taxable benefit.
Another loan forgiveness program exists for direct Federal Stafford loans when a graduate goes to work in certain public service positions. If working for a qualifying employer, a borrower must make 120 consecutive monthly qualifying payments. At the end of the 10 years of repayment, the loan may be forgiven and the amount forgiven is not taxable. Before committing to this type of loan forgiveness program, a borrower needs to be sure that they are repaying the right type of loan, are making the right payments, and have the right type of employment to qualify for the program.
Private loan refinancing programs are also more available in recent years. The benefit of these programs is lower interest rates and possibly better terms and conditions. However, a large consideration before utilizing these refinancing programs is understanding the favorable loan options and consumer protections present in initial Federal or private loans that may be lost upon signing up for loan refinancing. Specifically, public service loan forgiveness, options to defer payments, or the discharge of loan balances in the event of death or disability are all loan features that may no longer exist under a refinancing arrangement.
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In the end, it is critical for parents and students to take a very planful and disciplined approach to the process of choosing a college. Gain an understanding of the costs and diligently research the financing options available. If a significant amount of the cost of college would need to be funded using high-cost, undesirable loans, strongly consider removing that college from the selection list. Face the reality that an education at certain schools just may not be affordable. As an option, consider whether attending a community college for the first year or two can be a strategy to make the school of choice affordable.
Making a successful college choice is a team effort between parents and students. Success with this process has an important financial element. A graduating student should have only a reasonable amount of debt, an amount that can be repaid and that does not place undo financial burden on them early in their adult life. Additionally, parents should avoid sacrificing their retirement to enable attendance at an unaffordable school.
If you would like to further discuss planning to fund a college education or repaying existing college loans, please feel to reach out to Bill or me.