Impact Of Borrowing For College
Over the last several years, college costs has increased faster than inflation and faster than
the normal pay increases for most Americans. According to the College Board, most
financial assistance to help pay for college expenses comes in the form of loans.
Almost every family can pay for the cost of a college education because everyone rich or
poor, can borrow their way through college.
Even though student loan interest is relatively low, many families do not think of the impact
on the student’s income to debt ratio after graduation.
If the student has a high income to debt ratio it could cause the student to pay higher
interest rates on car, home, and other consumer debt. High indebtness is not an ideal way of
starting a career.
However, it does not stop here.
Parents are now borrowing more to help pay for college expenses.
The payments on these loans could cause financial problems for many parents and could
have an affect on the parents’ retirement accumulation goals.
Most families only look at the tuition cost of attending college and overlook the other cost
involved. Tuition and Fees are only one third of college costs.
Since most families have not saved for college expenses and most students will not qualify
for scholarships and grants, there are only two ways left in order to pay college expenses:
Paying For The Cost From Ordinary Income… or
Borrowing The Needed Cash
Since most parents think they do not have the cash from ordinary income, they run to
borrowing the money for a quick fix and worry about paying it back later. Most parents are
not really concerned about the amount of the debt they take out. The real concern is how
much will it cost the family on a monthly standpoint.
Many families feel that borrowing funds for college is their only alternative in order to cover
educational expenses. However, most families do not realize they have several options
available to cover college expenses without relying on LONG TERM DEBT.
PLUS (Parent Loan For Undergraduate Students) loans are easy to obtain. Because this
loan is given out mainly based on your credit payment history. Your debt-to-income ratio
could play a role in getting this money for college.
This could be very dangerous for the financial wellbeing of the parents. Borrowing too much
money in the parents’ name could have a drastic affect on future borrowing needs, not to
mention taking money away that should be placed aside for retirement.
IMPACT ON STUDENT
Borrowing too much money in the student’s name could also have a negative affect on the
future debt-to-income ratio of the student once the student receives a degree and enters
the job market.
If a student (after graduation) can keep their debt-to-income ratio of 10 percent or less, it is
considered very good, (excluding holding a mortgage).
A debt-to-income ratio of 20 to 28 percent is acceptable after graduation as long as the
student’s income is enough to manage the debt, (excluding holding a mortgage).
If a student has a debt-to-income ratio of 40 to 50 percent they are in the danger of not
getting needed credit and could cause the student to pay high interest rates on consumer
debt.
If you have to borrow for college, make sure it does not have a negative consequence on
other future borrowing needs as well as the impact on your retirement.
Let’s take a look at the impact of borrowing for college. Below we will outline the cost of
borrowing in relationship to the parents’ Debt-To-Income Ratio and how it will affect the
parent’s retirement goals.
Example: Family makes $93,000 a year and has the following debt:
Home Mortgage - $168,000 with a monthly payment of $1,980
Car Payment - $18,000 with a monthly payment of $365
Credit Card Payments - $10,000 with a monthly payment of $148
The Debt-To-Income Ratio of this family is 32% which is in the fair/good category.
Let’s assume a parent borrowed $40,000 in Direct PLUS loans over a 5 year period to help
cover the cost of a $17,000 ($85,000 over 5 years) public university. As you will recall the
interest at the present time for PLUS loan borrowers is 7.9% and normally repaid over a 10
year period.
PLUS Loan Payment - $40,000 with a monthly payment of $496
Interest Paid Over 10 years - $19,513
Total Money Paid Back Over 10 Years - $59,513
The Debt-To-Income Ratio is now 39%, which is getting near the DANGER ZONE of 40% 50%.
If the parents had to borrow additional money, they could find they could pay higher interest
rates and possibly have trouble securing additional debt.
Now let’s look at what affect the PLUS Loan has on their retirement. Let’s assume the parent
that took out the PLUS Loans was age 50 and had 15 years from retirement. If he had
invested the $496 a month into a tax deferred investment over a 10 year period, made no
more deposits after the 10 years and received a 7% return on his investment, his total
accumulation at age 65 would be approximately $123,412.
Let’s look at what the true cost of the student’s college education was for the parent.
Interest paid on the PLUS Loan - $ 19,513
Plus -
$123,412 in potential retirement accumulation
Total
$142,925
Many families feel it only cost $40,000 for the education, but based on this example, it cost
the family $142,925. This is a difference of $102,925 ($142,925 - $40,000). Of course this
does not take into consideration the potential tax deduction the parent could received
(Maximum of $2,500 interest deduction a year). However, if we did take this into
consideration the approximate tax savings over the 10 year period (based on a 25% tax
bracket) could be less than $4,100.
Now let’s look at the cost to the student that borrows $23,000 over a 5 year period (this is
the average debt according to the College Board).
Example: Student starting income after graduation is $38,000 and has the following debt:
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Student Loans - $23,000 with a monthly payment of $261
Car Payment - $8,000 with a monthly payment of $155
Credit Card Payments - $3,000 with a monthly payment of $60
Rent - $800 a month
The Debt-To-Income Ratio of the student is 40% which is in the DANGER ZONE.
If the student had to borrow additional money, they could find they could pay higher interest
rates and possibly have trouble securing additional debt.
FINIAL NOTES ON BORROWING FOR COLLEGE
A college education is a ticket to a better quality of life for most college graduates.
Unfortunately, some students and parents do not think clearly about select the right college
that is affordable and can give the student the education that they are wanting to pursue.
Many student will pursue the most elite colleges without thinking about the potential debt that
this decision could cause. Regardless whether the student attends a high cost private
college or an in-state university, not taking the cost of borrowing into consideration when
selecting a college could destroy their chances for a brighter future.
Robert Shireman, executive director for the nonprofit Project on Student Debt said,
"Excessive student debt, often made without an explicit decision on its impact on
future life choices, not only restricts traditional career choices but the basic ability of
young people to take risks – requiring them to defer their dreams."
According to the National Association of Colleges and Employers, students graduating from
college in 2008 will earn an average salary of $36,400 a year. This seems like an adequate
income for a young individual. However, if you look at the income on an
after tax standpoint the student will only clear approximately $27,500 or $2,300 a month after
taxes.
According to federal tables, 2008 graduates will spend on the average $1,800 to $2,000 a
month for rent, utilities, out-of-pocket healthcare, car payments, gasoline,
insurance and, entertainment. However, these figures do not take into consideration of social
debt or debt pertaining to credit cards, personal loans, and money set aside for emergencies
or retirement.
Therefore, before selecting a college, the student and parents should think about how much
the education will cost and the potential income that their degree will produce before
borrowing any money to pay for the education.