SAVE FOR COLLEGE OR RETIREMENT? WHAT YOU’RE NOT TOLD

Paying for college has been the theme of this important series using a three-prong approach. First is saving for college using accounts like the 529. If you have seen any recent news on the topic, you likely have a fundamental understanding of how this account works. This step also uses other savings vehicles. The second prong is to shop for colleges that fit your needs financially, socially, and academically.

Today’s article addresses perhaps the biggest question that influences families that are college shopping: Do I fund my child’s education or my retirement? The extent to which a parent favors one answer over another drives the family’s ability to pay for college. The last step we will explore involves saving on the cost of college.

We will review the issue of funding college versus funding retirement, why it is important and the standard industry advice. Ironically, the standard falls short in helping families answer this question. Inherit problems will be highlighted with the standard advice. We will wrap up the article with examples that demonstrate why saving for retirement first may be a bad idea. As always, you should check with your team of professional advisors to see how any of the concepts, terms, or ideas apply to your situation.

Why is funding college versus retirement such an important question?

Middle-class families live on limited incomes. A middle-class family must decide what to do with these incoming dollars. Do they save or spend the funds? If they spend, what do they buy? On the flip side, for which goal does the family save? Even knowing which goal should take the top priority, the family must make decisions about which vehicle (stocks, bonds, CDs, etc.) and account (Roth, IRA, taxable, 401k, 529, etc.) to use.

Several studies on American savings and habits clearly explain the stress we experience in our financial lives. With goals that cost millions (like retirement) or $100,000 or more (like college), is it any surprise that we stress about finances? It isn’t that families plan to fail in meeting their goals; instead, they fail to plan. To meet our goals, we must face the pain of discipline now; otherwise, we will face the consequences later. With limited income and expensive goals, where does a family save extra dollars?

Standard industry advice

The financial services industry tells families to save for retirement first. After this goal is met, the family can save for college. The language most families hear is something along the lines of “You can’t borrow for retirement, but kids can borrow for college.” Let’s look at a few examples from popular financial resources.

The article from Howstuffworks.com titled “The Kids’ College Funds Can Wait. Save for Retirement First” makes several points about why parents should save for retirement first.

– As previously mentioned, there are no loans for retirement.

– Working later because you funded your child’s education isn’t a plan. Forces outside our control – like a job loss or disability – can spoil our plans.

– You may be doing a disservice to your children if they end up supporting an elderly parent. While you may have paid $100,000 for their education, you did not save the $300,000 or more required to take care of yourself. Your child may end up footing the bill.

– Roth IRAs are a reasonable vehicle for college and retirement savings.

Consider the points from a Vanguard blog post, “Save for Retirement and College.” Here, the author suggests that you prioritize retirement before any other goal. “First and foremost, pay your future self. Unlike college, you can’t take a loan for retirement.” Second place on the priority list should be paying down debt, followed by a rainy-day fund. Saving for college should take fourth place, according to this author.

Carrie Schwab-Pomerantz also chimes in on the subject in a post called “Saving for College: Understanding Your Options.” Here, Carrie answers a question from a mother who is wondering about saving for college for her three-year-old child. College costs and savings vehicle information is shared. Carrie states:

“As parents, it’s natural to want to put our children’s needs first. But you can use loans to pay for your child’s education if you have to. You can’t get a loan for retirement. So, as important as college is, our retirement should always come first. Think of it as another way of taking care of our children, by ensuring we’re financially independent once we’re no longer working.”

The last financial guru, Dave Ramsey, leads his followers in “Retirement of College Funding: Which Comes First?” by asking “What is more important—my own security at retirement or my child’s education and future? There’s a lot of emotion wrapped up in that question, which makes it easy to come to the wrong conclusion.” Simply put, in his “Baby Steps,” Dave prioritizes retirement over college for a reason. “You’ll depend on your retirement savings to live, eat, and pay for shelter—the basics. If you’re not working, that money is your only source of income.”

Are you convinced?

With the industry gurus taking the same side of the coin, it seems pretty convincing that saving for retirement should be a priority over saving for college. I was part of this crowd for years until my oldest daughter entered her sophomore year of high school. I started looking at data and noticed these articles, which pointed towards studies in which parents took money out of their retirement accounts to pay for college. The data and studies were verified.

However, two items started making me question this advice. First, I hadn’t read an article with any numbers that stated why saving for retirement over college was better. Second, I started understanding why parents pull money out of retirement accounts to help pay for college. I’m not advocating this as a smart move, but rather acknowledging an understanding of behavior. I’m in the same situation as the middle-class parents. Advice from high-income earners (likely many of the financial gurus noted above) seems to make the subject a little less relatable from an emotional standpoint. We parent, live, and make choices emotionally.

Contrarian standard

In 2015, Mark Kantrowitz, a financial aid expert, wrote an article for Time.com called “Saving for College vs. Saving for Retirement: Why the Conventional Wisdom is Wrong.” Mark did the calculations and reviewed a couple of scenarios while dispelling financial planning myths.

– You can’t take out loans for retirement. Simply put, a couple over the age of 62 who has adequate home equity may take out a reverse mortgage or reverse equity line of credit.

– In fact, borrowing money to pay for college was a bad idea. Check out the article for the data. (Exploring it in detail here would make this article too long.)

Does it ever make sense to borrow money to pay for college?

Mark’s article highlights a specific situation. “The only time borrowing for college costs is financially beneficial is when the interest rates on parent loans are lower than the equivalent long-term earnings rate on your investments. But that just doesn’t happen very often.”

Currently, Direct PLUS loans carry an interest rate of 7%. Most financial plans assume rates of return of between 5%-6.5% depending on the portfolio, planner, and timeline.

Why does the financial services industry tell parents to save for retirement first?

To start, there’s a conflict. As I noted in my Current State of Affairs post, most advisors earn a commission for selling a product or they receive compensation from the assets they manage. Few charge by the hour or charge a flat fee. These same people and institutions will help families look for ways to fund goals that don’t take money away from the generation of revenue. Looking at the conflict another way, college will be coming before retirement and is less expensive. From the advisor’s perspective, the parent or student should take out a loan. The goal is funded and the advisor isn’t paid less. The loan will be dealt with later.

Next, outside of a few individuals, the industry doesn’t know how college funding works. Savings, loans, scholarships, work-study programs, class hours taken – these all influence the cost of college. Few if any discussions or works are available about how to shop for college. Families must match the student with the best college from the beginning; this can reduce time in school and transfers, the latter of which increases costs.

The reality is that parents will likely be on the hook for at least some of the student loan debt if they haven’t saved. The federal government will allow only $27,000 in student loan debt over four years with Stafford loans ($31,000 between subsidized and unsubsidized). The rest will come from either PLUS loans, private loans, or home equity. PLUS loans require a parent to participate, and private loans usually require a cosigner. This, again, places the matter back in the parent’s lap. The solution is to make college funding part of a family’s plan to shop for and save on higher education.

How many advisors and financial service professionals work in the trenches?

Based on my experience, very few (specifically, doing things like helping families fill out the FAFSA). Personally, I enjoy volunteering twice a year at College Goal Sunday. Families bring in their information and we walk through the FAFSA. No selling, just helping kids get into school and giving information to Mom and Dad.

Beyond the conflict and lack of understanding of college funding, the industry forgets that financial planning has value to the end client only when the plan is based on the client’s own values, not what we impose on the client. If a family ranks college funding over retirement, the advisor has the responsibility to build the plan that way AND to educate the family about the tradeoff between funding college and/or retirement. With more information, the parent better understands his or her choice and the cost of his or her decision.

What do you do?

– Take a deep breath. As a parent, I want the best that I can give my children. If that means working longer or having a little less at retirement, fine. I understand the choice and cost of this decision. Most parents have the same mindset of giving the best they can to their kids. To save for retirement over college seems contrary to how we parent and makes some parents feel as though they are being selfish.

Put your advisor through the paces and see how clear the college funding portion of your plan is. If it only states saving $x’s/month, you may be in trouble. Have a young child? Your advisor must, at a minimum, use a process or method to help beyond the savings component.

– If your student is in high school, use these articles to help you understand college funding. Download this worksheet to develop a college funding snapshot. This will help you understand how much the family can afford today.

Have more questions? Call to schedule a time for us to talk at 317-805-0840.

HOW TO PAY OFF STUDENT LOANS

If you have been following this series of blog posts, you know that college funding is the focus. The process, while easy on the surface, requires three steps. First, save for the cost of college. Many sources – from bloggers to financial publications – discuss this topic, and large financial institutions tell you how to save for college. The second step, shopping for colleges, has been the focus of the last two blog posts, which reviewed trends in college funding and how to pay using the different types of student loans. We continue with the second step of the discussion: paying back student loans. The last step will help you save on the cost of college.

First Student Loan Conversation

As a Certified Financial Planner, I was not aware that dealing with student loans would become a common planning topic in the same way that planners now help Boomers with Social Security planning. I became aware of this need only a few years ago. In 2010, I had my first conversation that shaped the way I see this crisis.

The son of a client came into my office with his new bride to talk about cash flow and getting his new life off to a great start. We talked about many of the normal things young couples desire: a nice home with a family, vacations, and cars. There were miles of smiles around the table as the conversation progressed.

Then I asked about income and jobs so that we could focus on making these dreams a reality. The conversation quickly came to a halt. The wife had just begun her first job and had a student loan that was large but workable. The husband sat quietly in his chair while the wife and I discussed the details of her income, student loans, and job. Noticing that he was uncomfortable, I asked the husband what was on his mind. He revealed that his student loan debt totaled just over $100,000. He did not work and was not confident that his liberal arts degree would allow for the lifestyle we had discussed.

This conversation drew my attention to the effect student loans can have on a young person’s life. Unfortunately, my professional life took me in another direction. I did not return to this negative reality until six years later, when we started college planning for my oldest daughter. This brings us to the important question.

What is the best strategy to pay back student loans?

Google the term “strategies to pay back student loans” and a plethora of articles will pop up discussing everything from making more than your minimum payments to refinancing your loans to taking on a job that provides forgiveness. While these methods have worked for some people, I subscribe to the keep-it-simple mentality.

Two strategies have proven successful among families that face a large amount of debt. Dave Ramsey created one of the popular strategies, called the Debt Snowball. This is by far my favorite strategy because it acknowledges the power of behavior. The strategy is simple.

  1. List all your debts on a piece of paper, from the lowest dollar amount at the top to the highest dollar amount at the bottom.
  2. Write out the minimum payment next to the loan balance.
  3. Make the minimum payment on all the debts except for the one with the lowest balance.
  4. Pay as much as you possibly can toward the lowest-balance debt. Before you know it, the debt will be gone.
  5. Scratch the debt off your list and start over. Make the minimum payments on all the debt except for the new one with the lowest balance. Again, pay aggressively on this balance until it is gone.

With this strategy, momentum builds quickly because of the quick victory in paying off a few of the lower balances. The student loan borrower will see that getting out of debt is possible and will not feel as overwhelmed. The downside is that this is not the optimal strategy financially. You may pay more interest because the highest-interest loan may not have the lowest balance. In my opinion, though, through the creation of a momentum-building sequence, the debt holder will stick with the strategy, thereby yielding better results.

Interest Optimization

The second strategy takes a similar approach but instead of listing the loans by balance, you list them by interest rate, with the highest on top. As with the Debt Snowball, you make the minimum payments on all loans with lower rates and pay aggressively on the high-interest rate. While this creates an optimal financial outcome, the average debt holder has a hard time creating momentum. The strategy is best suited for those who easily understand how debt and compounding work.

The other strategies that you would see in a Google search typically involve one-off actions like refinancing. You may lower your interest rate, but did you extend the term of the loan or give up other provisions by moving away from federal loans? Taking a job that provides forgiveness may translate to lower take-home pay. Think about the difference in pay when working for the government or a company.

Spending Plan

You may have noticed that both strategies require “paying aggressively” toward one of the loans. This means creating margin in your monthly cash flow. How do you do this? First, you avoid using the word “budget.” This word interrupts financial progress. People associate budgets with micromanaging and doing without.

Creating a spending plan means balancing those things that are most important to you while creating the margin to put toward your student loan debt. You do not have to focus on where every dollar goes; rather, consider whether each purchase creates the highest level of happiness for you or your family.

Two methods can be used to create my favorite style of spending plan. The simple versus may be completed using four different-colored highlighters and your bank statement. The second method requires more effort or a spreadsheet. For purposes of the conversation today, the simple version will be the focus.

Simple Spending Plan Instructions

First, pull out your bank statement and use four highlighters, each for a different category: highly important, moderately important, could do without, and savings. Next, decide what goes into each bucket. Third, total the amounts for each category. Fourth, figure the percent of total spending for each category.

The goal is to create margin in your financial life. Savings should account for 12-30% of your income, while highly important and moderately important should account for the rest of your spending. If, for example, you encounter a lack of savings, you must prioritize your spending so that the lower, can-do-without expenditures can be moved to the savings category. For example, is living in your current place important to you, or is it the features/characteristics that you like? If the latter is the case, find a cheaper way to get those features and characteristics. The goal is to start looking at your spending in ways that promote the important facets of your life. Work with the number until you meet the 15-30% threshold. Slowly work on getting the can-do-without cash flows off your bank statement, then move the cash flow into a savings vehicle that starts increasing your savings bucket. Once you have the cash flow straight, a small amount of savings will likely have accumulated; you can use this to pay down student loan debt or, more importantly, act as an emergency fund. Now you will move the cash flow that built your savings to aggressively pay down the debt.

Student Loan Refinancing

Having followed the exercises above, you have created a margin in your monthly cash flow and know which debts to aggressively pay down first. Next may come the question of whether you should refinance or restructure your student loans. Exercise caution when addressing this topic and consider the following points.

– Beware of income-based repayment plans and their true long-term cost. You are trading dollars today and tomorrow for much later.

– If your plan is to simply find a job after school, you could be missing out on opportunities for student loan forgiveness. This may change, but states also offer student loan forgiveness programs. Reference the other article I have already written.

– When consolidating federal loans into a private loan, you may be giving up the following: income-based repayment options, access to student loan forgiveness programs, and forbearance and deferment options.

Wrap-Up

A payback strategy is great; start small and work on building momentum. Use the technique above to build your emergency fund. Once you check off these two items, you can address the next common hurdle that many parents face.

Should parents of teenagers save for college or retirement? Even younger millennials try to answer this question with their young children. Keep an eye out for the next article, which examines this dilemma.

 

STUDENT LOAN TRENDS

The last article focused on step two of the college funding process. It reviewed the types of student loans and broke them down into federal and private loans, as well as the subcategories of student and parent loans. Today, we continue by discussing student loans and the student loan crisis. Will there be a crisis or is it already here? What trends are taking place with student loans?

Funding College with Student Loans

Seven out of ten families will use some form of student loans to help pay for college. Many families accept this statistic as a normal part of sending a student to school. Some families see the current debt load of $1.4 trillion and focus on creating a lower or no-debt funding plan. The goal for later families is to help control early expense risk (increasing needed cash flow to duties that do not normally exist). With few or no student loans, young workers can save for retirement, a house, a baby, or other goals.

Problems do exist for students who have student loans and no degree. A worker with a college degree earns more over a lifetime than does a person without one. Imagine how much further behind a college drop will be when student loan payments enter the equation. Not only will this person earn less, but his or her expenses will increase.

Government Limiting Risk

As strange as it sounds, we can thank the government in some way for helping limit the expense risk that students face – specifically, those students who did not earn degrees. You may recall from the post Different Types of Student Loans that the federal government limits how much a student can borrow based on his or her year. Freshmen can borrow $5500, sophomores can borrow $6500, and juniors and seniors can borrow $7500. The caps limit risk by not letting underclassmen take out too much in federal student loans.

These limits make sense when one considers the high number of students who drop out of school. In risk management, this would be an example of risk reduction. The student’s risk of default does not go away but rather is limited to the lower amount of the Stafford loan. In terms of other types of student loans, this trend moves in the opposite direction. A quick review of the data below shows the point.

Notice the 25% growth in Parent PLUS loans and the almost doubling of the nonfederal loans? These are the loans that start getting families in trouble, which begs the question: How does this happen after more than a decade? After sitting by some of the families and helping them fill out their FAFSA forms this fall, I have no doubt that the process of going to college creates large amounts of stress for the student and the parent. Many feel that completing the FAFSA is not only harder but more stressful than completing their tax return.

When families receive their acceptance letters and aid packages, the sense of relief overcomes them and they pay little attention to the financial aid package. As consumers, we must keep in mind that these non-friendly loans become collateralized with Mom and Dad’s names or assets. Bankruptcy does not necessarily dismiss the debt, either.

Here we sit, in $1.4 trillion of student loan debt.

Student Loan Crisis

When do you call something a crisis? Is it after we push the ball off the cliff, or just before the tipping point of going over the cliff? Experts disagree on the answer, and some contend that a crisis does not exist. However, we cannot dispute the data. The following graph shows a different story (1.)

Nearly one-third of the federal education loan portfolio is in deferment, forbearance, or default. Not all delayed payments under these programs are negative. A student may qualify for a deferment for several reasons, like active duty, military service related to a war, a military operation, a national emergency, or enrollment in an approved rehabilitation training program for the disabled (2.). Other scenarios may qualify a person for deferment.

Simply looking at the default rate should make us uncomfortable. Mortgage delinquencies during the great recession topped out at 10.53% (3.). We are sitting at nearly the same rate on student loans. The public keeps sloughing off the concern. Major ramifications will likely result if the default rate continues increasing, which may drag on for some time. As mentioned before, student loans typically cannot be written off in a bankruptcy. Banks wrote off the bad mortgages from the Great Recession. For capital markets to work efficiently, this write-off process should be short. The markets then quickly adjusted to reprice the mortgage. The default of a student loan has the potential to go on for years or maybe decades as long as the borrower remains alive. Markets cannot be efficient with the current state of affairs, and inevitably delays the likely result of not recovering the principal amount of the loan.

Possible Crisis Scenarios

You know from my other posts that student loans have a negative effect on the individual. For example, when families have student loans, they save less for retirement and delay having children. Blow this effect up nationally and imagine how things change. The question to answer is: How do student loans with extended defaults affect spending and economic patterns?

What if it was easier to declare bankruptcy on student loans?

Perhaps the financial markets would be able to absorb the disruption more quickly than forcing a delay and extended process for dismissing the debt. Of course, the normal and negative side effects would accompany the dismissal. The family/individual would be able to move forward more quickly. Today, the issue is politicized, with no progress made in terms of reform or in the ability to dismiss the debt. The courts still use a standard – called the Brunner test – established in 1987 (4.).

Even debt holders using income-based-repayment plans face some economic challenges. By dragging out payments over 20 or 25 years, the worker pays more interest, which is not going toward other desired outcomes that contribute to current or future economic output. To put it another way, more dollars are spent on the past than on the present or future.

The current system has produced no significant changes. As mentioned before, debt has increased at a ridiculous rate. A rising interest rate environment creates a squeamish outlook for students who take out future loans and for those who hold variable rate loans.

Perhaps a different form of “forgiveness” should be reviewed, or we should let the markets help decide the fate of delinquent loans.

Next Step:

If your student is college bound, take the first step and create a college funding budget. Consider it the rudder on a ship; it will provide direction and prevent your student from facing the student loan crisis problems that this post has outlined. Second, create a smart lending strategy. This means knowing the rough starting salary of your career. The student should not graduate with more in debt than his or her first year’s salary. Shop for a school that meets the needs of your student socially, academically, and financially.

For those in school, take the time now to estimate the debt you will have accumulated upon graduation. Will you be eating ramen noodles or living the way you expect? If the former, make changes now to limit the damage. Take on a shift at a local business or at school. Do not borrow money for spring break trips. Take more credit hours or go to summer school so that you do not extend your academic career by another year or two.

Before your student heads off to college, make sure you know how much you can afford by using the free College Funding Snapshot Report.

Have questions? Call me at 317-805-0840 or email me at ncarmany@thewatermarkgrp.com.

Sources:

  1. Trends in Higher Education Series. PowerPoint. 30, October 2017.
  2. https://studentaid.ed.gov/sa/repay-loans/deferment-forbearance#deferment-eligibility
  3. https://fred.stlouisfed.org/series/DRSFRMACBS

http://www.studentloanborrowerassistance.org/bankruptcy/