By David J. Haas, CFP®
July 14, 2020

A college education has become a truly expensive expenditure. One year in a reasonably selective private college now costs approximately $75,000 with room and board. Four years of college might cost $320,000 or more, and the finaid.org website reports the price of college is going up 8% per year. Public state colleges can be slightly better. For my home state of New Jersey, the current price tag is approximately $35,000 per year or about $150,000 for a four-year degree.

So How are Parents Supposed to Pay for College?

Let’s examine a particular American family. Joe and Helen Jackson have two children: Rachel, age 12, and Paul, age 16 and thinking about attending college.

Joe and Helen want to fully fund Paul’s education at a private university. If they had thought about saving for college when Paul was born, they might have opened a 529 plan and started saving then. How much would they have had to put aside and invest for 17 years to end up with $320,000? If they invested in a diversified balanced portfolio, their investment return over those 17 years might average 5.5% per year. They would have had to save $11,850 per year for 17 years in order to end up paying fully for Paul’s four year college education. But they have two children, so they would have to save $23,700 per year. Families with four children have to think about saving approximately $47,000 per year to pay for their college. No problem!

Of course, very few parents open a 529 plan, one of the best ways to save for college, at the birth of their child. Usually parents are worried about putting food on the table, paying for dance lessons and soccer camp. They start thinking about paying for college when their children enter high school, sometimes even later. By then, being able to pay the full sticker price is beyond most parents’ capabilities.

The Jackson family did save a little, but like most families, not enough.

College Funding Reality for Most Families

The Jacksons only really thought about the cost of college when Paul was a junior in high school. At that point, they had saved a bit and received some monetary gifts from a grandparent. According to The College Savings Plan Network, an association of 529 plan providers, the average 529 plan balance was $26,054 as of December of 2019. But, Joe and Helen are better savers than average and actually expect to have $50,000 saved for Paul by the start of his post-secondary education.

The Jacksons believe strongly in education and are ready to sacrifice to send their children to college. They decide that delaying a new car, working overtime, and forgoing family vacations will allow them to provide $10,000 per year out of their cash flow for Paul’s education.

The Jacksons have provided $10,000*4 years + $50,000 = $90,000 towards Paul’s $320,000 college education bill. Now how will they fund the rest?

College Net Price

Every college tells you their sticker price, but it turns out many students don’t pay the sticker price. Students can be eligible for two types of financial aid: merit and needs-based.

Merit-based Financial Aid

Colleges may give students a discount on their sticker price based on how badly they want a particular student to attend the college. Factors considered include the student’s academic record, test scores, sports activities, music activities, and demographics. Moderately selective schools might give a big discount for students with high academic achievement. Colleges might give a discount for a tuba player, where they might not for a trumpet player, because they might really need that tuba player for their band. The factors surrounding merit aid will vary based on the match between the college’s need and the student’s achievement in any given year.

Merit aid can even vary based on how much interest the student shows in the college. Did that student go to visit the college? Did they call the admissions office to ask questions?

Demographic factors include where the student lives. Colleges want to provide a well-rounded experience for their students and this includes creating a national profile. So if you are attending from out-of-area, you might be more likely to get a discount (increased merit aid).

High school guidance counselors tell students to apply to at least 6 colleges: two “reach” schools where the student is not that likely to get in, two target schools where the student will probably get in, and two safety schools where the student is sure to get in. Merit aid is almost always a form of scholarship (or discount from the sticker price). It is the best aid to get because it won’t be in the form of loans which will have to be paid back later. The problem with merit aid is that it will be most available at the least selective schools, those safety schools.

Paul, like many students,  wants to go to the most selective school he got into, not the cheaper safety school which he thinks is beneath him.

Needs-Based Financial Aid

Colleges also provide aid based on family financial circumstances. The family fills out the FAFSA (Free Application for Federal Student Aid) form. This standardized form is used by most colleges to determine EFC (Expected Family Contribution). The FAFSA asks questions about income, number of children, and financial assets of the family.

The FAFSA formula assumes a family needs a certain amount of income for basic spending and it varies depending on the size of the household, but for a family of four with one college student, the basic excluded income is $28,580. Everything over that amount is called net available income and the FAFSA formula assumes 47% of that is available to pay for college.

How does this work for the Jackson’s family income of $120,000? The formula determines the family has $42,967 available to pay for college.

In addition, parents and the student are expected to use their savings: 5.64% of parents’ savings (including 529 plans) and 20% of a student’s savings can be allocated towards EFC. Going on with our example, the 529 plan has $50,000 in it. Let’s just assume that the Jacksons have another $100,000 in after-tax savings or investments of which 5.64% is $8,460. So, adding that up, the college could assume the Jackson family can provide $51,427 a year.

If the college costs $75,000 per year, then the good news is that the college will provide $23,573 in aid, right? Unfortunately, the answer is only maybe. Colleges can give aid in many forms and some of those forms may not be as attractive to the student. The aid could be in the form of loans and/or a campus job. In fact, the college might provide very little scholarship cash.

The Family Conundrum

In this example, Paul wants to attend a college which costs $75,000 per year. The family has to figure out how to some up with $28,927 per year to cover the difference between the aid and the sticker price.

Here is where there are several traps which the Jackson family can fall into.

The Student Debt Trap

A student is allowed to borrow more than $5,500 for their freshman year, just not using federal loans. Paul can take out private student loans, co-signed by Joe or Helen, to finance the gap. If the gap for the whole four years were financed with private student loans, then Paul might graduate with $140,000 or so of debt. All this additional debt is co-signed by Paul’s parents. What does the profile look like for paying this debt back?

Life After Graduation with Enormous Debt

If the average interest rate on the debt is 4% (private student loans are usually floating-rate debt) and the loans are to be paid back over 15 years (a slightly extended payback period), then Paul will have to pay $1,013 per month for 15 years. What will Paul’s budget look like after graduation? If he has a starting salary of $55,000/year, then the budget might look like this:

This budget is pretty tight and it stays tight for 15 years. Paul will be almost 40 before he can escape the burden of his debt. If Paul graduates with a degree in the arts, he may have a considerably lower salary. The budget does not include any savings for retirement or a house down payment. Many people go through periods of unemployment for all kinds of reasons and while loan deferments are available, interest continues to accrue. It’s no wonder young people are not buying homes and often delaying starting a family.

Raiding the Retirement Savings Trap

The Jacksons, who are both 50, have been saving for retirement all along. In fact, they have managed to save $200,000 for their retirement, all in their 401(k) plans. This is probably not enough, but Joe and Helen are planning to increase their contributions after their kids graduate from college. The Jacksons own a home with about $100,000 of equity in it.

What are their choices to fund almost $30,000 extra a year for four years for Paul’s education? They could take a home equity loan of $40,000 to fund part of it. They could take a maximum $50,000 loan from their 401(k) and still take a taxable distribution of an additional $40,500 from their 401(k) plans (assuming their employer plans allow in-service distributions). This will net them $30,000 after the taxes and the 10% penalty on the early distribution. After they did all this, they will have taken on $40,000 of additional family debt and reduced their retirement nest egg to only $109,000. But they have sent Paul to the private college that they feel he deserves.

What Happened to their Retirement?

Remember they have a younger daughter, too. What will happen when they need to send her to college? Joe and Helen had wanted to perhaps retire early, but now they will be working to age 70 and maybe beyond if their health holds out. They could get lucky and both continue to earn well, but older workers often lose their jobs and can find it difficult to get new jobs which pay as well. Retirement would have been tight before, but now it has become very difficult and frightening.

The Balanced Approach to Paying for College

Helen and Joe did some things correctly when they were considering how to send Paul to college. They created a budget and determined exactly how much they can pay out of their cash flow. They also had dedicated funds that they had saved in a 529 plan to use for Paul’s schooling. Of course, they want to give their son the college education he wants, but they should have communicated with him upfront about the budget constraints. It is not fair for Paul to carry the debt burden, nor is it fair for Joe and Helen to endanger their retirement in order to send their two children to college.

Paul should have applied for colleges which were likely to have a lower net price. This means applying to those state and other schools that might really want him as a student. This might mean looking at different geographic choices or colleges where he is one of the better students academically. There was a $28,927 gap between the needs-based aid and the list price of the college. If Paul had gotten a $25,000/year merit aid package, it would have reduced the gap to $3,927/year. At that price, the Jacksons could have considered a combination of some small extra student loans and a home equity loan to fill the gap.

The college application and decision process today is as much about finances as it is about academics and personal fit. If a student really wants to go to a particular college, it makes sense to try to bargain with the school for aid. This is especially true if the student plans to go on for higher degrees. In that case, the university they get their PhD from is much more important than the college they receive their BA from.

A financial planner should be able to help a family with this decision. It is extremely important to plan out how to pay for a higher education. A knowledgeable financial advisor can help avoid the debt and retirement traps and ensure the college decision is a positive one.