The Benefits of Saving vs. Borrowing for College
Written by Lisa Bleich
When our first daughter was born in 1994, UGMAs (Uniform Gifts to Minors Act) were touted as the best way to save for college. We readily set up an UGMA in her name thinking that with the benefit of time and compounded interest, we would be set for college. When our second daughter was born in 1996, we did the same. Of course, that money, did not accrue any interest and actually lost money over the course of several years. Frustrated by our poor investment, when our third daughter was born in 1999, we set up a 529 in her name and transferred the money in our UGMAs into a 529 as well.
We set up an automatic monthly investment into our accounts, faithfully believe that dollar cost averaging would benefit us in the end. During the 2008 crash and turbulent market, we often had our doubts and like many other parents who lost money in their 529s, started to wonder, if we would have been better off not saving and just hoping to get some financial aid or scholarships when the time came.
But then, over the course of the past few years, the market rebounded. As our second daughter is in her sophomore year of college, we feel grateful that we continued to save, even when the markets looked bleak.
In Ron Leiber’s, October 23, 2015 NY Times article, Why It Makes Good Sense to Save for College Now, he explains clearly the benefits of saving vs. borrowing for college. He also outlines the different types of aid.
My colleague, Lora Block, also brought to our attention an interesting tool that can help families with younger children grappling with the same decisions compare the cost of saving today vs. borrowing tomorrow.
She writes: “Below is a link to a rough and ready calculator to help families see the difference between saving (e.g. a 529 plan) vs. the cost of borrowing.”
You need to put in your own assumptions about how fast you imagine college costs will rise, what you think the cost of college will be, etc., The default on the calculator that a 529 plan might earn 6% is very unrealistic– they usually earn much less, so she recommends changing it so something more conservative. But even so, this is a good exercise. Lora provides the following examples:
For a child who is 10 years old now: Based on a current cost of college of $25,000, a college inflation rate of 4% and an assumed investment return in your 529 plan of 3%, paying for the entire four-year cost of college would require monthly contributions to your 529 plan of $970. Your total contributions would be $128,022.
If you were to instead borrow the full cost of college, your monthly loan payments (assuming a loan interest rate of 6.5%, the Parent PLUS loan rate now– which can rise to 9.5% maximum, and a 10 year repayment period) would be $1,650. Your total loan repayments will be $197,968.
Lora also cautions that this calculator does not include how saving for college can lower a family’s eligibility for financial aid. In this scenario, the family’s savings of $128,000 would be counted as a parent’s asset and assessed at up to 5.64% of the value. Therefore the student would be eligible for $18,000 less in aid over the 4 years—(This was derived by calculating 5.6% on a declining balance of the 529 each year if 1/4 of the total is used each year to pay for college.)
In comparison, this scenario above shows an additional cost of $70,000 in loan payments if the parents borrow the full amount vs. saving the money.
So if you have the ability to save for college when your kids are young, it can definitely pay off from a financial perspective.