As we enter autumn, the leaves start to change and students arrive at college campuses across the country. For parents, as well as for students, the start of the academic year raises the specter of some of the largest costs that a family incurs. Hopefully, families have started to prepare for college costs far ahead of the years of attendance, but the sheer size of the expenses may be pretty daunting even for those who have saved since their children are very young.
There are a variety of sources with which to pay for college. First, there is savings. Second, there are grants and scholarships. Third, there is part-time work, summer employment, and work-study and cooperative education. The fourth way to pay for college, of course, is by taking on loans.
Colleges increasingly assert that they will figure out a financial package that will make it possible for your child to attend if he or she gets accepted. To get a sense of how colleges will view your finances and how they will decide your eligibility for aid, it is illuminating to experiment with some of the online aid calculators that different colleges provide. Here is the one for Princeton, for example. These will give you a sense of what a college may expect your family to contribute, given your assets, income, and other factors. These figures are for the current year. If you are planning a number of years in advance, you need to use a calculator that estimates likely future costs. Once you have a ballpark sense of how much you will need to have saved or otherwise provide out-of-pocket, you can start to really plan.
I think that the simple calculator provided by Savingforcollege.com is a great place to start for checking on your progress and planning savings. The calculator takes current college costs and projects forward based on an assumed average rate of annual cost increases. You, the user, can adjust the baseline annual rate of cost increases and this is a critical variable. If the current annual total cost (tuition, fees, room, board) of your public in-state university is $23,000 per year (the national average according to the website), and you have four years until your child attends college, the calculator estimates that you will need $114,000 to cover the total cost if costs increase at an average of 4% per year. That’s a bit below the 4.8% that tuition and fees increased in 2012-2013, but my assumption here is that other costs such as food and housing will grow much less rapidly, bringing the average rate of price inflation down. This assumes that your child receives no financial aid, scholarships, or grants. If you want to get more detailed, you can use the online aid calculator at the college of your choice and then enter the estimated ‘family contribution’ amount as the annual cost of attendance in the calculator.
The second step in determining how you will be able to cover the costs of college is figuring out how much you need to save in order to meet this expense. This is where the attractive simplicity of the calculator shows its flaws. You, the user, need to estimate the average rate of return that you will generate on your investments and the baseline value assumed in the calculator is a return of 7%. Even if this is a realistic long-term average return for a well-diversified portfolio, the calculator is treating this return as if it is risk-free, which is an unrealistic assumption. If you invest in a mix of assets with an expected 7% return, there is some real possibility that you will have a negative cumulative return over the next four years until college. Any portfolio with expected return as high as 7% per year also carries a real chance of loss. Let’s assume that you can get a 5% risk-free return over the next four years, even though that is still too high. There is no risk-free investment yielding 5% that I am aware of.
The key to completing the second step is entering how much you have saved currently and how much you will save per month. If you have $40,000 saved for college and four years until your child starts college, you need to save $658 per month from this month until your child graduates college (eight years from now, to stay with the earlier example in which you have four years until your child enters college). If you have only $10,000 saved so far, you will need to save $1,080 per month from now until college graduation. On the other hand, you could save nothing and simply pay for college out-of-pocket in four years, at an average estimated cost of $2,375 per month for the four years of college.
Assuming that you are saving and investing to help pay for the future college costs of your children, the third step in the process is determining how to invest the money. The current low-yield environment makes it very hard for investors to generate returns much above inflation without taking on meaningful levels of risk. I explored this issue in the context of retirement savings in a recent article, but it also has bearing on saving for college (or any other long-term goal). I assumed a 5% annual rate of return on college savings in the example above, but even this level of return comes with risk. A portfolio that is 50% allocated to stocks (S&P500 index) and bonds (Barclays aggregate bond index) has an expected return of 5.3% according to a model which I developed. The math for the expected return is simple. The model assumes 8.3% per year as the expected return for the S&P500. The model then estimates the expected future return for the bond index at 2.52% per year. This is low, but a range of research suggests that the best prediction of the future total return from bonds is the current yield and this index has a current yield of 2.43%. If you have a portfolio that is 50% of each of these two asset classes, the average return is 5.3%. This portfolio carries risk, which means that your certainty of reaching your savings goal is lowered. If, for example, the stock market suffers a large decline, you may end up with considerably less than the full amount you need to cover college costs. On the other hand, if you take no risk at all, you will need to save more to account for the loss of potential growth from higher-return asset classes. Cash is, for all intents and purposes, yielding zero. If you keep your college savings in cash, the only truly risk-free asset, you will need to save $884 per month from now through college graduation, as compared to the previously-estimated $658 per month with a hypothetical 5% risk-free rate of return.
Choosing the right amount of risk depends on your family’s ability to make up a shortfall in the balance of the college account.
In Part 2 of this article, I explore more specific examples.
The main points from Part 1:
- There are a variety of ways to pay for college, but colleges assume fairly substantial family contributions—check their online calculators
- Once you have a sense of what you would pay this year, you can use the calculator at Savingforcollege.com to estimate what you are likely to need to cover costs in future years
- The calculator can also provide estimates of how much you need to save each month to meet the future costs of college
- The necessary savings rates only make sense if you input a reasonable assumed rate of return on your investments
- Ignoring investment risk will lead to potentially substantial under-estimates of the savings rates needed to have a high confidence in your ability to meet your financial goals
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