Student Loans

For parents with children planning to attend college, two common questions about the financial side of planning for college are:

1. Is it worth it to save for college?

2. If we do, are we penalized for saving?

The short answers are, 1) yes, and 2) maybe. The reason the answer to the first question is yes is that saving is better than borrowing, no matter what the circumstance. It is always better to have interest paid to you when you save money rather than to pay interest to someone else when you borrow money.

Let’s look at an example to help illustrate this point.

The Johnsons are savers. This family started saving for college when their son Timmy was five years old. They put aside $175 each month, which added up to $2,100 per year. After 13 years, they will have $27,300 saved. If their return is 5% per year, by the time Timmy is ready for college at age 18, they will have accumulated about $40,000.

The Baker family did not save any money for their children’s college educations. As their daughter Jennifer is about to start her freshman year, the Bakers look at how much of their income they can use to pay Jennifer’s college expenses. They decide they need to borrow $10,000 per year, or $40,000 total, assuming she finishes in four years and her expenses are the same each year. The interest rate is 6.8% with a 10-year repayment period. After Jennifer graduates, she gets a repayment schedule from her lender. Her total debt, including both the principal and the interest, comes to $55,238.

That $40,000 of borrowed money turned into $55,238 of debt.

It is clear with this comparison that the Johnson family made the wiser financial decision. For the same $40,000, they paid $27,300, while the Bakers will have paid more than $55,000.

Saving for college by itself is a good idea, provided the family doesn’t do it at the expense of maintaining normal living standards, putting aside money for emergencies and having an adequate retirement plan. Even without the comparison to borrowing student loans - remember, the $27,300 still turns into $40,000 - it is reasonable to measure saving against borrowing because loans are the primary means of paying for college in today’s world.

Assume that based on this information, we agree with the idea that setting aside an affordable amount each year makes sense. (Incidentally, it is wise to start saving for college when each child is born, but at least begin by age 8 so there will be 10 years of contributions and the accumulation of interest.)

Suppose that, over time, a family sets aside about $50,000 in a 529 plan. Based on the cost of college by the time the child enrolls as a freshman, it’s possible that this amount is not enough to pay all the college expenses, and it is necessary to apply for financial aid.

To go back to the second question, if a family does save, are they penalized for it? The answer is “maybe” because it depends on how the saving is done. If the $50,000 in the 529 plan is the only savings the family has, most of it will be protected from the calculation a school will make about how much a family needs to contribute. The “need formula” used by the federal government and the schools is the total cost of attendance less the amount the family can contribute. The difference is the need upon which financial aid is based. The formula includes an asset protection allowance so that the first $50,000 worth of savings in a 529 will not have an impact on the family’s eligibility for financial aid.

Assume the family has an additional $50,000 in savings or investments that maxes out the asset protection allowance. The $50,000 in the 529 plan is subject to the need formula and will increase the expected family contribution by about $2,500. If we assume that the $2,500 won’t need to actually be paid until well into the academic year, the family actually comes out even. Using a 5% return on the college savings, the family can earn back nearly the entire $2,500 in interest.

The bottom line is that the need formula will ask each family to contribute anywhere from zero to an amount that will need to be covered from the return on any college savings. In the end, that doesn’t seem like such a “penalty” for saving.