By D. Abraham Ringer, CFP
Wondering how much it will cost to send your kids to college some day? The answer depends on a number of factors, including:
- the school your child chooses;
- the financial aid package awarded;
- scholarships; and
- inflation rates on tuition between now and then.
These factors are typically beyond your control.
But one factor you can control – and that may have the greatest impact on the cost of your child’s college tuition – is when you pay for college.
Most of us understand that college will cost us more if we borrow the money for college rather than save for it. However, few truly understand the full implication of this difference. When you save for college, you leverage your savings with investment returns (assuming positive returns over the investment period). When you borrow to pay back college, leverage is still being used; however, it is the bank that is benefiting from it.
Let’s look at a very simple example to illustrate this point. Say that your newly born child decides to go to University of Massachusetts (UMass) Amherst someday. For the 2013-14 school year, UMass Amherst costs $23,198 annually for in-state tuition, including room and board (www.umass.edu/admissions/facts-and-figures/tuition-and-fees). Assuming an annual 6 percent growth rate in tuition, UMass Amherst should cost approximately $66,215 per year by the time your child gets there. The total cost for all four years will end up being $289,664, provided the annual 6 percent tuition increases continue while your child is attending school.
So how much will it cost you to pay for this $289,664? If you are fortunate enough to be able to fund a college savings account at your child’s birth, it would cost you $77,270 to be able to fully fund this account. This figure assumes that you achieved an average annual 7 percent growth rate over the entire investment period. The $77,270 number is so low compared to the actual cost of tuition because you are leveraging your savings with compound interest to lower your overall cost of college.
Now let’s look at this from the other side of the equation. What if instead of saving, you borrowed to fund the cost of college? How much would that cost you?
To keep it simple, let’s assume that the interest was subsidized while your child was attending college, and it did not accrue during this period. In this case, assuming a 20-year loan with a 5 percent interest rate, four years of college will end up costing you (or your child) $458,797. Put another way, saving for the college in our example rather than borrowing for it resulted in it being one-sixth the cost.
Clearly, this is an extreme example because few of us would have the resources to save 100 percent in advance. However, the point is that no matter how much you can save now, the long-term effect of these savings could be multiplied in reducing the total cost of college.
Once you’ve resolved to save more for college, there are a variety of financial vehicles that can help to make your savings as efficient and impactful as possible. One of the most popular of these vehicles today is the 529 College Savings plan. This state-sponsored plan allows you to grow your college savings on a tax-deferred basis. As long as the distributions are used to fund higher educational expenses, then distributions from the account should be tax-free. However, if you needed to use the money for purposes other than higher educational expenses, then the gains on those distributions would generally be subject to income taxes and a 10 percent penalty on top.
In conclusion, by using compound interest to your advantage, rather than your disadvantage, every dollar you save in a 529 plan or other savings vehicle will make a disproportionate dent in what you’ll owe for college.
D. Abraham Ringer, CFP® is a Financial Adviser with Morgan Stanley Global Wealth Management in Boston. He is registered in MA, NH, NY and several other states to which this article is directed. For more information please consult www.morganstanleyfa.com/ringer.
The information contained in this article is not a solicitation to purchase or sell investments. The strategies and/or investments referenced may not be suitable for all investors as the appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives. Investing involves risks and there is always the potential of losing money when you invest. Morgan Stanley Financial Advisors do not provide tax or legal advice. The views expressed herein are those of the author, D. Abraham Ringer, and may not necessarily reflect the views of Morgan Stanley Smith Barney LLC, Member SIPCwww.sipc.org, or its affiliates.