Why bother saving for college?

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Today’s young families are faced with an endless amount of new challenges and responsibilities. Kids can be surprisingly expensive. With regular everyday expenses like diapers, clothes and activities, it’s hard to imagine putting away money for things like retirement and college. Furthermore, many parents put off saving for their child’s college education because they are still making payments on their own student loans. These parents often feel comfortable with the idea that if they fail to save enough, their children can also rely on loans. The idea of borrowing money to pay for education has become so popular that in FY 2013 the federal student loan portfolio surpassed $1 trillion with over 40 million borrowers. (Source: 2013 Annual FSA Report).

Why Not Rely on Student Loans?

Sure, maybe our parents didn’t open college savings accounts. We took out loans and it worked out just fine. Unfortunately, times have changed. In 1999, the average cost of attending 1 year of a public 4-year university including tuition, books, fees and room and board was $8,086. This year, those costs are estimated to be almost 3 times as high, at $22,826. (Source: College Board).

In addition to rising costs of higher education, loans themselves may actually become more expensive. The recently approved Bipartisan Student Loan Certainty Act of 2013 states that interest rates on Federal Direct Loans are now updated annually to reflect market rates. A borrower in today’s low interest rate environment could certainly benefit from his type of loan structure, but future students will pay the price when rates go up. The government has placed a cap on federal student loan interest rates, but students can still end up paying up to 8.25 percent.

What happens when Federal Loans aren’t enough?

Backed by the government, Federal Direct Loans are currently the best choice for families who choose to borrow. However, an incoming freshman filing as a dependent this year is limited to $5,500 for an unsubsidized direct loan. As mentioned above, the average costs of college this year will be around $22,826 for a public 4-year university, leaving a balance of $17,326.

One way to supplement a federal loan is to borrow from a bank, credit union or other private lender. These loans are considered less favorable because in most cases, private lenders do not offer the flexible repayment terms or borrower protections available through federal loans. Additionally, in a private loan the lender sets the interest rate limits, which are often variable. In a variable rate loan, the interest rate can fluctuate throughout the life of the loan. This can make payments significantly more expensive when rates are high and can also be difficult to budget (Source: Consumer Financial Protection Bureau).

The True Cost of Loans

Just how much are parents willing (or willing to let their child) pay for a college education? Let’s say the average total cost of 1 year of college in 2013-2014 will be around $25,000. If parents of a 2-year old child today decide to wait and borrow money for college, their monthly loan payments after graduation would be $2854 (assuming a loan interest rate of 8 percent and a 10 year repayment period). This equals a total cost of $342,452 for a 4-year degree.

Compare this to a family with a 2-year old child that instead chooses open a 529 college savings plan. After making monthly contributions of $604, by the child’s freshman year the family will have saved $137, 616 (assuming an investment return of 6 percent and the current college inflation rate of 5 percent). Over the long run, the parents who borrowed will end up paying $204, 836 more for the same degree.

How much are you willing to pay for college? Find out how much your loans will end up costing you with our Savings Vs. Loans Calculator.

Securing the Future

As tuition costs continue to rise and incomes remain stagnant, preparing for future college expenses is more important than ever. Student loans are one of the few types of loans that are rarely forgiven, cancelled or discharged. Even in the event of a bankruptcy, a borrower is still held responsible for making payments. Graduating classes of recent years were hit especially hard with this truth. These students borrowed heavily to pay for their education and were faced with one of the country’s worst ever job markets upon graduation.

Proactively saving for college allows parents to secure the benefits of higher education without the burden of excessive debt, even in the event of an economic downturn or unemployment crisis. With investment vehicles like a 529 college savings plan, families earn interest on money saved instead of paying interest on money already spent.