Journal of Financial Planning: February 2017
Paying for college is one of the greatest financial challenges facing middle-income America today. College costs continue to rise at nearly twice the rate of inflation. As a result, our national student loan debt has grown from $240 billion in 2003 to $1.3 trillion as of March 2016—that’s an increase of more than 510 percent in just the last decade, according to a 2016 study by the Global Financial Literacy Excellence Center at George Washington University. The Federal Reserve estimates we are adding $2,726 per second to our student loan debt, putting us on pace to add nearly $100 billion this year alone.
While the majority of families will have some amount of student loan debt in their college funding solution, graduates leaving college with too much debt may be forced to delay their lives. They may not be able to save for a house or for retirement, and they may delay getting married and starting families of their own. According to the independent, non-profit Institute for College Access and Success, seven in 10 (68 percent) graduates from public and non-profit colleges in 2015 had student loan debt, with an average of $30,100 per borrower. As a rule of thumb, for every $10,000 borrowed, they will owe $100 per month over 10 years.
The four-year sticker price of college today ranges from $100,000 (in-state) to $250,000 (elite/private)—that’s a $400,000 to $1 million investment in education for a family with four kids. We are tasking 17-year-olds who may have never had a job, paid taxes, or had any exposure to personal finance to make one of the largest buying decisions of their life before their adult life has even begun.
Many parents know that getting a good education at a reputable university is an investment worth making in their children. In 2014, the median earnings of young adults ages 25 to 34 with a bachelor’s degree ($49,900) were 66 percent higher than the median earnings of young adults who only completed high school ($30,000), according to the National Center for Education Statistics. Those with a bachelor’s degree also reported higher job satisfaction and quality of life; so, college remains a good investment—as long as you don’t overpay for it.
Simply put: the way we shop for college is all wrong. Our role as financial planners needs to go beyond simply telling clients to save for the cost of college. Telling parents things like, “There is only one way to pay for retirement and lots of ways to pay for college” is not helpful. The advice most planners provide needs to change. This article proposes a new approach to providing college funding advice.
We need to help families understand how financial aid works and provide them with strategies to cut the cost of college, reduce the stress and anxiety surrounding college funding, and ease the guilt that they have not done enough to prepare. It starts with understanding all the moving parts. How do we look at their current situation and put together an executable plan for them? We need to help families understand not only what it costs to send their kids to college, but how they will actually pay for it. Do your clients know exactly how they will pay for all four years of college down to the penny, including student loans and the monthly payment for their child upon graduation? You can’t look at paying for college in a vacuum. You must look at the whole picture including balancing current lifestyle with retirement and college funding goals.
Most clients at this stage in their lives are in their late 40s to early 50s. Retirement is just around the corner, and this may be the first time that they really have had to face a major expense of $25,000 to $65,000 per year for four years. Our job as financial planners is not to tell people what to do, it is to guide them toward building an integrated financial solution that looks at college, retirement, investing, cash flow, and tax planning. Don’t just tell clients that they need to focus on retirement. Help them understand the trade-offs they are making.
Families need to know how to shop for colleges that will provide them with the most financial aid based on financial need of the family and/or the merit of the student, and some families may wish to determine this before they schedule a college visit.
Getting Pre-Approved for College Funding
I would love to drive a Lamborghini, but that doesn’t mean it is a good financial decision or that a bank would give me a loan for one. When you buy a home, the first step is typically working with your bank to get a mortgage pre-approval letter. You are asked about your entire financial picture—down payment amount, income, assets, where you work, employment history, your credit score, etc. The banks are calculating what you can reasonably afford. Can you get pre-approved for the same mortgage as LeBron James? Probably not. The bank will only pre-approve a mortgage amount that they are confident you can repay based on your financial resources. College should be no different.
Before the college search process begins, every family should go through a college pre-approval process just like buying a home. As financial planners, we are always looking for ways to add value for our best clients. What if you could reduce the stress and anxiety of paying for college by facilitating a meaningful conversation with your clients and their college-bound teen in making a smart financial decision for college? This exercise will give them hope and show them how normal families pay for college and close the gap between what they have saved and the cost of education.
My firm, Capstone Wealth Partners, has developed a three-step process we call College Pre-Approval™ using a one-page college funding plan—no fancy software needed. Here’s how it works:
Step 1: Determine Available Personal Resources
The clients’ available personal resources include 529 plans, other savings, cash flow, grandparent help, and tax benefits.
Savings. How much has the client been able to save for the cost of college for their student in 529 plans or other vehicles? (Be sure to help clients allocate funds for each child; they likely don’t want the eldest to go to their dream school and suddenly have nothing left to pay for the other children.)
Cash flow. College is a cash flow crunch. When it comes to college, it’s critical for clients to get a handle on their cash flow. For example, the cost of attendance at a college includes room and board. When students live at home they are not free. So, when they are living away from home, can the family continue to commit a certain amount each month? A number we frequently hear is that they cost at least $300 per month.
In addition, if the client is currently contributing $100 per month to a 529, add that amount to the monthly commitment since they are already used to paying for it. That makes $400 per month while in school, which adds up to $4,800 per year, or $19,200 toward the cost of a four-year education. Many schools offer zero-interest payment plans, frequently referred to as installment plans, where they will work with families to spread the payments over the semester (be sure clients understand any costs associated with this option).
American Opportunity Tax Credit (AOTC). The credit equals 100 percent of the first $2,000 of a student’s qualified education expenses plus 25 percent of the next $2,000. The maximum annual credit is $2,500, which adds up to a maximum of $10,000 over four years of undergrad.
Unlike other education tax credits, the AOTC includes expenses for course-related books, supplies, and equipment that are not necessarily paid to the educational institution, but room and board expenses are not qualifying expenses. The AOTC can be claimed in the same year that clients take a tax-exempt distribution from a section 529 plan or a Coverdell Education Savings Account, but the distribution may not be used for the same qualified higher education expenses. Many families may be planning to use all 529 monies for the first year or two and then tap other resources. To ensure they get the AOTC each year, you need to carefully coordinate a four-year funding plan.
Step 2: Establish a Maximum Student Loan Amount
It is critical that we proactively help families develop a well-thought-out lending strategy. As a rule of thumb, students should not take out more in student loans than their first-year salary will be in their chosen career upon graduation to avoid getting in over their heads. Consider two students paying the exact same price to attend the same university. Student 1 is a teacher coming out of school with a starting annual salary of $40,000, versus Student 2 who is an engineer coming out of school with a starting salary of $60,000. An engineer could afford a larger loan because his or her starting salary would be 50 percent larger upon graduation.
In other words, the amount invested in the education and the resulting loans needed to finance the education should be considered in the equation. And, clients should be very clear about the total amount of loans they are taking out for the entire four years.
Loans come in two forms, federal and private (bank). The student loan nearly every family will consider is the direct federal loan; this is typically the best loan for the student. These loans are taken out in the student’s name, do not require a cosigner or underwriting, and they have reasonable interest rates (currently 3.76 percent, reset every July 1). If the student can graduate with no more than the $27,000 in direct loans, he or she will have manageable student loan payments of around $275/month upon graduation and in some cases be eligible for loan forgiveness.
The U.S. Department of Education offers eligible students at participating schools direct subsidized loans and direct unsubsidized loans, and clients must file the online Free Application for Federal Student Aid, or FAFSA, to be considered (fafsa.ed.gov).
Subsidized loans are need-based. The student must qualify based on financial need, and no interest accrues while the student is in school. Unsubsidized loans are offered to every student regardless of financial need, but interest accrues while the student is in school. They are available only up to a set amount each year, and each year’s maximum loans are “use it or lose it” loans, so if the client doesn’t use any or all of the $5,500 loan amount available during the student’s freshmen year, they will not be able to borrow that $5,500 in a subsequent year. We frequently see families using their personal resources up in the first two years and then not having enough money for the second two years, forcing them to take out private loans to meet the difference.
In regard to the federal direct Parent PLUS loan, we caution our clients. Parents can borrow up to the total cost of attendance less financial aid. Without good guidance, clients may see the Parent PLUS loan as an easy, temporary solution without fully considering the long-term ramifications. These loans are expensive (currently 6.31 percent with a 4.725 percent origination fee), and they are non-transferrable. Avoid having parents take on education loans altogether unless it is a small amount to fund a small gap.
Private loans are made by banks and financial institutions. They are a rapidly growing section of education loans because the loan amounts are unlimited. However, students and parents should only consider a private loan after they have maxed out all the federal loan money available. Interest rates, loan fees, and repayment terms can vary immensely. In most cases, they also require a parent cosigner.
Step 3: Shop for Schools Within the Budget
Help clients project their net cost at different institutions and understand the role financial aid will play, whether it be need-based or merit-based. Every college and university is required to have a net price calculator on their website. Advise clients to visit the appropriate sites, plug in some numbers, and determine estimated costs. Once they have estimates from their choice schools, clients should also look closely at which colleges award which kind of money—need-based or merit. What is the college’s financial aid policy? Two great resources to research this are collegedata.com and collegeboard.org.
Help clients understand that colleges are a business, and they are really good at what they do. They have a great product to sell and they will do all they can to convince prospective students and their families that their institution is worth paying a premium for, and it very well may be—within reason. As consumers, we need to find the best college education for our dollar and spend as little as possible.
You do not have to become a financial aid expert to help clients make informed college funding decisions. We meet with hundreds of families every year, many of whom currently work with financial planners, and we go through this exercise with them in as little as 15 minutes. We always ask them what their planner has done to help them establish a college budget. The answer without fail is, “That is not the kind of work they do.” This simple exercise can make a huge impact and truly add value to your relationship with your clients.
Joe Messinger, CFP®, ChFC®, CLU®, is partner and director of college planning of Capstone Wealth Partners (www.capstonewealthpartners.com). He is a trusted authority in the area of college planning and funding, and is frequently asked to speak to professional groups and parents to demystify the college financial aid process. Through his work with Capstone College Partners, (www.capstonecollegepartners.com) he is on a mission to empower financial planners with the tools they need to help families beat the high cost of college.
Sidebar:
Sticker Shock
Here is some good news: the “sticker price” of college is irrelevant. Clients should never rule a school out based on the top line price. Similar to shopping for a car, they should never pay full price if they are an informed consumer and know how to shop.
The average discount rate for first-time, full-time freshmen at private, non-profit colleges was 48.6 percent for the 2015–2016 school year—a figure 10 percentage points higher than a decade ago, according to a recent study by the National Association of College and University Business Officers.
For example, if a private university is priced at $50,000 per year, and we know that they are discounting the cost 48.6 percent, the out-of-pocket cost would be $25,700 per year after financial aid. The key is knowing how the financial aid policies work at each of the universities being considered.
—J.M.