In the last blog post, The Current Reality of Paying for College, we discussed the nature of college funding, the misalignment between the financial services industry and parents, and how we parent. Specifically, we examined the details behind the Student Loan Bubble and compared default rates to the mortgage delinquencies of 2008. The numbers show that the student loan bubble is already here. For those with current student loans, a new mindset must lead the way in creating innovations that minimize interest paid over the loan’s lifetime. Families with college-bound students must focus on how they save for, shop for, and save on the cost of college. This blog post reviews the first of three steps in saving and shopping for college, as well as the cost involved.
Before we dive into the specifics, we must ask a question.
How do families currently approach college funding?
A new trend worth noting shows that an all-time-high number of parents are saving for college: 72 percent according to a recent Fidelity survey (1.) Seventy-six percent of the respondents are very or somewhat familiar with the popular 529 account. The survey discusses three knowledge gaps: 1) how much a family should be saving and the future cost of college; 2) understanding the fundamentals of 529 accounts; and 3) how saving for college affects financial aid eligibility (1.)
The last point of the study deserves clarification. The study mentions having grandparents help save for college but doesn’t describe how to do this. If money is gifted to parents who then put the funds into a 529, then yes, there is minimal impact on the FAFSA funding formula. However, if grandparents put the funds directly into the 529, then pay the school from the account, major implications may affect financial aid during the student’s following school year. Up to 50 percent of the money distributed from the grandparents’ 529s may be taken away in need-based aid. This is where working with a fee-only financial planner may help.
Increased savings will benefit college-bound students. However, as noted in the three gaps from the Fidelity survey, understanding the cost of college is important. Financial aid trends in grants, loans, and tax credits play another important role in financing higher education.
College Funding Sources: Loans
The following bar chart highlights the difference in federally subsidized loans on the funding percent from the 96-97 school year to the 16-17 school year (2.). This funding source was cut by more than 50 percent. By comparison, notice the large increases in federal unsubsidized, Parent PLUS, Grad PLUS, and nonfederal loans.
The increases are worth noting because of the large financial strain they put on students and parents. In my other blog post, you can see the result of this strain. As further proof of the difficulty in servicing these large increases in student loan debt, take a look at the following chart (2) showing deferment, forbearance, and default. Keep in mind that filing bankruptcy on student loans is difficult.
Is easy access to money partially to blame for this increase in student loan debt? It seems that little regard is given to students’ ability to service the debt beyond graduation. This comment does not dismiss consumer responsibility but rather acknowledges the behavioral aspect of shopping for college from a consumer point of view.
How we shop matters.
How we shop matters to the point that financial institutions limit how much we can borrow. Imagine going to the Ferrari dealership as a fresh college grad making $45,000 a year and applying for a car loan. What would a bank tell a young couple trying to buy $1,000,000 on an income of $75,000? Of course, the bank will say no. In fact, the bank will pre-approve you for an amount so you know the maximum price range in which you can shop.
Wise and informed consumers will have a much lower self-imposed limit and will shop around for the best bargain. Why do lenders limit the amount you can borrow? The lender must limit the risk associated with your total debt load, which makes credit scores, income, and assets part of a standard review before one borrows money for a major buy. These debts can typically be claimed as part of a bankruptcy.
Student loans have much lower standards for borrowing money. Over their undergrad years, all students qualify for up to $27,000 in Stafford loans with no questions asked and no credit check. Parent PLUS loans do require a credit check but there is no total limit on the loans. Private loans vary, but I meet people coming out of college with hundreds of thousands in student loan debt. Can you blame the student loan lender for these low standards? As mentioned earlier, it affects the student and, likely, the parent.
As consumers, we must treat the college shopping experience the same way a bank imposes limits on how much one can borrow for a home. Also, we do not buy the first home we see. Instead, we look for homes that meet our needs at a great price. Valuing the education from one institution may be similar to the way in which we value both market aspects and personal preference in pricing a home.
College Funding Sources
There are five broad personal funding sources: parent resources, parent loans, student resources, student loans, and other help. Scholarships and grants may pay for college, but the family does not have control over whether the money is awarded.
Parent resources include both income and assets collected for college. Here are a few examples: 529s in the parents’ name, taxable brokerage accounts, Roth IRAs in which the money was saved specifically for college, monthly cash flow (kids do not live with parents for free and may cost $250-$300/month), tax credits (for example, the Annual American Opportunity Tax Credit), 529 state tax credit, and public matching programs like Upromise or the Hancock County Promise in Indiana.
Parent loans typically include Parent PLUS and private student loans as the two most common ways for parents to borrow money to pay for college. A third possibility includes taking out a home equity loan. If you are a parent over the age of 62, a reverse mortgage may be another avenue to examine. (Please consult with your financial advisor to review how these may or may not fit your needs.)
Student resources include income and assets similarly to parents’ assets. Many of the same types of accounts apply but with a few differences. Taxable accounts are referred to as UTMA or UGMA accounts, and the parents typically decide about the funds. If monthly cash flow exists, it likely comes from a part-time job. Parents usually claim the tax credits while the child attends college (normally, the child remains a dependent for an undergrad degree). Do not forget that these assets weigh heavily in determining the expected family contribution (how much the government thinks you can pay for college).
Student loans start with Stafford loans, then move into private loans. When a student enters the private loan market, usually a co-signer must be on the loan. Make sure all parties understand the loan’s covenants. Students often get in trouble because they do not understand how the debt works after graduation or if they drop out of school.
The last category covers all other sources of funding. Grandparents gifting money to mom, dad, or grandchild and 529s saved in the grandparent’s name are the two most common funding vehicles in this category. Families must be aware of how this category may affect any financial aid the student receives.
A good college funding budget would look similar to the example below.
One final important detail must be addressed. Notice the First Year Salary and Student Loans sections. These numbers should help set the maximum student loan debt a graduate should accumulate after leaving college. For every $10,000 in student loan debt, you should expect roughly a $100 payment for 10 years. Because not all majors produce the same level of income, the student should accumulate the appropriate level of debt.
- Gather your tax return, W2s, and asset statements.
- If you do it yourself, work with your student to create a college funding budget.
- Work with an advisor? Schedule a meeting with you, the student, and the advisor to walk through this college funding worksheet.
- If you need help, contact me at firstname.lastname@example.org or call 317-805-8040 to schedule a time for us to walk through your college funding budget.