Given a choice, most of your clients would rather pay for their kids' college education from accumulated savings or an overabundance of current income (if not a full ride based on the child's expertise at Guitar Hero).
But when those sources of cash are not enough, many parents reluctantly turn to public and private education loans to make up the shortfall. Their reticence is unfounded though, because it's much better to borrow money to pay for college than to not go at all. And in many situations, a loan is preferable to some of the alternative sources of funds.
Here's why your clients should embrace borrowing money for college — and the sooner, the better.
- IT'S CHEAP MONEY
Interest rates on new subsidized Stafford student loans (typically awarded on the basis of need) are currently at 6.8 percent, and the interest doesn't begin accruing until after the student has left school. Perkins loan rates are only 5 percent, yet these types are harder to obtain, and are typically only awarded to the neediest of students. Rates for private loans, and loans to parents, are slightly higher, and are often tied to the prime rate.
Up to $2,500 of annual interest paid on education loans is typically tax-deductible, as long as the borrower (student or parent) has less than $70,000 of modified adjusted gross income ($140,000 for married filing jointly). Let's assume the borrower has $20,000 in education loans at 8-percent interest. If she's in the 25-percent tax bracket, the effective after-tax cost is 6 percent — about the lowest rate she'll ever find for unsecured debt.
- IT BEATS WORKING
Most fiscally responsible parents would prefer that their child earn as much money as possible by working during the school year and the summer. But that may not be the best monetary move, especially if it means time on the job keeps the kid out of the library and the classroom.
Let's say a student is entering college $20,000 short of funds needed for the next four years, and is considering either borrowing the money, or working 12 hours per week at eight bucks an hour for as long as he's in school.
Getting a job seems to make the most sense, as he would graduate debt-free. But what if the time spent working prevents him from taking a larger course load, which then requires an extra year (or more) of school to get a diploma?
He and his family not only incur the additional cost of the fifth year of college, but he also misses out on the year's worth of salary he would have likely earned from getting a “grown-up” job after graduation.
- NOW OR NEVER?
There are two reasons parents of college students should consider borrowing money right away — even if they already have a goodly sum set aside in a designated account. The first is that like every other group of debt providers, private education lenders are tightening their purse strings, or even leaving the business altogether.
If this trend continues or gets worse, families looking to borrow money down the road may come up short once their college-savings accounts are spent. But those who borrow now can always tap their savings later if interest rates on new education loans go higher, or lenders get even more finicky about whom they finance.
And even if loans for college become more available and at more favorable terms down the road, the family may endure a job loss or medical crisis that makes them wish they could draw on their savings for the more urgent need.
- SKIN IN THE GAME
The second reason families should consider borrowing first and liquidating assets later is that some initial debt incurred by the student can provide the sobering focus needed to do well in school and get out with a diploma.
If the student finds bars and parties more interesting than books and professors, he may flunk out in hock for loans that he would be forced to repay without the benefit of a college degree. The parents, meanwhile, can use the savings for their own purposes, or redirect the money to a more motivated and deserving family member.
Once the child demonstrates a commitment to his college courses, the parents can then use savings to pay for the final years of an undergraduate degree, or pay off education loans the kid incurred while in school. Keep in mind, though, that 529 account distributions are only tax-free if the proceeds go to pay for current education expenses, rather than to pay off outstanding student loans.
- NO LOANS FOR RETIREMENT
Finally, there is the reality that a fresh-faced freshman has four decades of earnings after graduation that can be used to pay off any student loans. In contrast, her middle-aged parents are facing the unknown cost and length of retirement, with only a few more years of employability left until the Golden Years kick in.
Whether the parents are really short on their retirement savings, or would prefer the student take on some debt for the reasons cited above, there may be a bit of resentment from her when she finds out she has to shoulder some of the cost of her scholarly pursuits.
But there's an easy way the parents can re-align their child's financial interests with their own. Simply have them tell her, “If we tap our savings for your college and then run out of money when we're old, we'll have to come and live with you until we die.”
That should be suitable motivation for even the most loan-averse student to plunge deep into debt.
Writer's BIO: Kevin McKinley
CFP© is Principal/Owner of McKinley Money LLC, an independent registered investment advisor. He is also the author of the book Make Your Kid a Millionaire (Simon & Schuster), and provides speaking and consulting services on family financial planning topics. You can reach him at [email protected].
COLLEGE BORROWERS ARE NOT A-LOAN
Portion of college graduates who have student loans: 2/3
Average debt among graduates with loans: $19,237
Average debt if PLUS loans are included: $21,899
Average total school debt of MBA borrowers: $41,687
Average total school debt of law school borrowers: $80,754
Average total school debt of med school borrowers: $125,819
Source: 2003-2004 National Postsecondary Student Aid Study (NPSAS)