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Education: Debt or Savings

Question: My husband is planning to start a two-year Master's degree program next fall (2008) which will cost about 24,000 total. We have enough money in savings to pay for most of the tuition, but I wonder whether it would be wiser to take out student loans for all of it and let our cash stay in the bank to earn interest for those two years. (We have no other debt other than a mortgage.) Suzan, Minneapolis, MN

Answer: To some extent this is a personal choice or preference. Some people in your financial circumstances just don't want to take on any debt. They prefer to pay out of savings. Clearly, that's a sound option.

But I'd like to argue for borrowing some to most of the money needed for the Master's program while leaving your savings alone. The reason is that when your husband graduates you could face a number of different choices, including moving to another city for a better job. Now, that may or may not be in the cards, but by keeping your savings your decision about what to do won't be constrainted by money when he graduates. And since there is no prepayment penalty with student loans, you can always pay off the debt at that time.

12/18/07 by Chris Farrell

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Student Loans

Question: A few weeks ago you advised a woman with a college-age daughter that there was not a big advantage to paying off her student loan early. I have a related question.

I recently went back to graduate school and had three separate loans for about $18,000 each, one for each year I was in school. I consolidated the first two years into one loan at an interest rate of about 3.5% but didn't consolidate for the final year because that year's interest rate was already getting very high. So I now have two repayments of about $250/month, one for the first two years, one for the final year by itself. I was considering an early repayment of that final year's loan which is currently at about 5.5%, higher than the average savings account interest, and which I assume will go higher.

But your earlier advice made me wonder if that was wise in my case, or did it only apply to college loans? Thanks! Becca

Answer: Every situation is slightly different. If I remember the earlier question right, it involved a short-term trade-off between husbanding savings and paying down debt. In your case, my impression from your question is that it's a savvy move to get rid of the higher interest rate student loans. As you know, it's always a relief to get rid of debt.

01/09/08 by Chris Farrell

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College Choice

Question: My son, a high school senior, was accepted to one of Minnesota's private colleges. We have been fortunate in that we invested over the years and have saved enough for about 3 years of his education at this school. He also received scholarships to a different MN private college that would pay for about 66% of his costs for 4 years, leaving him with a substantial amount of $ at graduation. I have 2 questions. He wants to turn down the scholarship and go to the other school. There is a difference in the 2 schools, one has a very strong regional reputation and the other a national reputation. He wants to forgo the scholarship for the national reputation. From a long-term $ perspective, what advice would you give to him? Second, assuming that he forgoes the scholarship, I am considering keeping the $ we saved for him invested and taking out loans to cover the cost of the education and then paying off the bulk of the loans at graduation. Is that a solid strategy? The investment has averaged 10% over the long term. Thank you for your advice. John

Answer: This is one of those times when the outcome of a financial decision is positive no matter what, yet people strongly disagree about the answer. Some of my friends are adamant that it doesn't pay to attend the more expensive, nationally known school. They'd leap at the scholarship money. Over the course of a lifetime, the importance of that degree shrinks, and the dollars saved add up. Other friends believe the national reputation is worth it if the student expects to attend graduate school, move to another part of the country upon graduation, or enter certain professions, like investment banking. To them, the extra money you're paying is the price of an "option" on a particular career choice and geographic mobility.

So, where do I come down? What strikes me over the past 30 years is just how good college and universities have become, including small private liberal arts colleges. The gaps in performance and quality have really narrowed even if national rankings haven't kept up with the transition. But your son has also expressed a clear preference for the better known school. One way to make this decision is insist that your son "own" more of his education. If he goes to the regional school, he graduates debt free--and that is a genuine advantage these days. He'll be in a position to choose a job at graduation based on desire (and perhaps a low income) rather than face the pressure to take a less desirable job that pays more because he has student loan bills to meet.

If he still wants to go to the other school, then I would have him borrow at least some money to pay the difference in costs himself. He won't graduate debt free. Instead, along with his diploma he will get a student loan repayment booklet. I think making the decision this way is a good life lesson.

That said, I would limit how much he borrows so that he still has a choice at graduation. For one thing, you have the savings. For another, you don't want him too burdened by debt. By the way, it can be a good strategy to borrow, even if you have the money, if there is a reason to keep your options open. You can always help them pay off their student loans at that point.

01/31/08 by Chris Farrell

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529 Plans

Question: How does a 529 plan affect a person in terms of financial aid eligibility? Samir.

Answer: The terrific thing about 529 savings plans is how many pitfalls it sidesteps. Your money compounds tax free. And when the money is withdrawn to pay for qualified college expenses, it's free of Uncle Sam's grasp. Most colleges and universities count it as a parental asset in the financial aid formula (meaning parents are expected to fork over 5.6% of their assets, which is much lower than the 20% figure applied to student money.) However, private colleges and universities are free to make their own rules and percentages. The bottom line: It pays to save for college, and a 529 plan is one of the best options available. .

03/11/08 by Chris Farrell

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Savings for Child

Question: my wife and I just had our first child. We are wondering what sort of investment/saving plan would be the best to start for him. We are looking to invest $100 a month. Thanks. Michael, Seattle.

Answer: Congratulations. First of all, you can't go wrong putting money on a regular basis into a tax-sheltered 529 college savings plan. That said, I have one other thought. How about putting the monthly savings into a broad-based equity index fund with razor thin fees (such as the Standard & Poor's 500 index, Russell 3000, Wilshire 5000, and the like). The savings is in your name. In 16 to 18 years, you'll have accumulated a nice pot of change. You can spend it on your child's college education. But maybe your child will get good scholarships. Then you can spend the money on yourselves, or perhaps create the family trip of a lifetime. You gain a lot of flexibility with this approach.

04/04/08 by Chris Farrell

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Saving for College

Question: On average, we save about $1000 a month. $500 of it goes to a 529 college savings plan for our son (he's about two years old). $200 goes to two Vanguard index funds (Total Stock Market and Total International) in our regular taxable account. And we put $300 in a money market fund with our bank.

The money market is now at about $7000, and we realize we don't have a good option to invest that money. We don't want to have the money sit in a money market account. Certainly not for 16 more years. Neither do I feel comfortable putting all of it in 529. Hence, I am looking for an option that (1) provides growth opportunities, (2) has low tax impact, and (3) has some mechanisms built in for age-appropriate auto-(re)balance.

In the last show, Chris mentioned tax-managed mutual funds as an option for semi-long term tax efficient investment. I looked at Vanguard's tax-managed funds. They all cost quite a bit to start, $10,000. So this doesn't seem to be a valid option.

What other options are available? I suppose that I can buy ETFs at a discount on-line brokerage as a way to boost tax efficiency and hold diversified investment stocks. I am not sure if, given the amount of dollars we are talking about here, ETF would be a good choice, e.g. the amount of saving on tax efficiency would offset other shortcomings of ETFs. I have a hard time thinking about or comparing ETFs with index funds. In addition, I will have to do age-appropriate asset re-allocation myself with the ETF funds. Because that would take time and discipline, it might not be an attractive option 10 or 15 years from now.

Another thought is to buy a Vanguard target retirement fund that sets my son's college entrance year as the retirement target year, say 2020. With this, I at least can have stochastic asset reallocation as a means to reduce portfolio risks. But I have no idea how tax efficient that fund is. And it probably is not. Thanks. Key, Cary, NC

Answer: Your question is extremely thoughtful, and just reading how you're thinking through the various options and trade-offs might help someone else decide what to do.

Fact is, I like what you're doing: a mix of a 529 plan, index funds and a money market fund. I hope that the index funds and money market fund are in your name so that if your son gets scholarship money, you can tap the savings for your retirement. I prefer the index mutual funds over ETFs because the former are ideal for adding money on a monthly or quarterly basis without paying the brokerage fees or commissions. So I would take some of the money market fund money and put it to work in the index funds.

One other thought: You could buy some I-bonds to add into the mix. The fixed 30-year rate of interest on the inflation-protected savings bond is currently 1.2% per year (plus the actual rate of inflation). But it will almost certainly fall when the rate is reset on May 1. The limit per person is $5,000 in electronic form at www.treasurydirect.gov and another $5,000 per person in paper form at banks. Still, you get a guarantee that a dollar saved today will be worth a dollar plus interest 16 years from now when your child goes to college. And the money compounds tax-deferred until you cash it in.

04/22/08 by Chris Farrell

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Coverdell College Savings

Question: I have 2 Coverdell IRA's for my 2 children, to which I contribute what I can. I've heard that the program is set to expire in 2010. 1) Is this true? 2) Does this mean I have to get the money out and close these accounts before 2010? My children are both under 10 years old. Brian, Ann Arbor, MI

Answer: You're right that a number of the college savings attractions attached to the Coverdell will end in 2010. I'm not really sure why Congress improved the 529 college savings plan in 2006 but left the Coverdell vulnerable. But it did. For instance, the Pension Protection Act of 2006 made withdrawals from 529s permanently tax free when the money goes toward qualified educational expenses, like tuition. What's more, the sums invested in 529 plans aren't considered a student asset in the financial aid formula calculation.

In sharp contrast, the Coverdell didn't get legislative protection. No, upgrade passed in 2001, such as raising the contribution limit from $500 to $2,000 and allowing tax-free withdrawals for K-12 expenses, are still slated to expire in 2010. The Coverdell will be then much less attractive choice for college savings. For instance, right now you can make tax-free withdrawals from a Coverdell to pay for college and still take advantage of the Hope or the Lifetime Learning credit. After 2010, you'll be forced to decide which benefit to take, the tax free withdrawal or the credit.

What to do? If you like your Coverdell accounts you can continue to make contributions into them. If the Coverdell bells-and-whistles do expire, you can always roll the money over into a 529. (It's a tax-free rollover.) You can gamble that Congress will get rid of the 2010 sunset date. Or you can open up a 529 plan for your children. No matter which choice you make, your savings will compound tax-deferred and your children will benefit from your thrift. I just wish Congress would stop all this nonsense about sunset provisions. It makes savings more complicated than it should be.

04/29/08 by Chris Farrell

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Co-sign for Law School?

Question: I am 58 years old, a self-supporting teacher, and anxious about my retirement savings. My son at the age of 29 has decided to go to law school, and asked if I would co-sign $14,000 of his student loan package. The thought of having my name attached to a debt of any kind is distressing. Am I being unreasonable?... And what about the immediate liability? Does the $14,000 go on my credit report until it's paid? Are there any liabilities to my credit, just for being a co-signer? Thanks for your advice. This is a heart-rending situation. I don't think I can say no, but the thought of being a co-signer at my age makes me VERY nervous! Carolyn. Carlsbad, CA.

Answer: I understand the desire to help out your son financially. But I would not co-sign the loan. You're right to worry that the risk is too great, especially with retirement looming. Put it this way: I assume your son has done the calculations that a law degree will pay off over time in higher earnings and better career prospects. Assuming that is the case, the debt burden is well worth taking. Time is on his side, and he should absorb the risk of something going wrong. You shouldn't be on the hook financially.

To be sure, one advantage of you cosigning the loan is that he will probably get a better rate on the loan. Again, it's really a question of whether the investment in a law degree will pay for itself. You could always make a small private loan to him on your home to help him out with an understanding that he'll pay you back later on.

05/20/08 by Chris Farrell

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Heloc vs. Student Loans

Question: Is it better to use money remaining in our HELOC, money in our savings account or to take out student loans to pay for our daughter's college tuition ($49,000.00)? Linda, Los Angeles, CA.

Answer: We've been getting many more questions about equity loans recently. When it comes to paying for college my approach is a mix of student loans, work-study, and parental savings.

I am wary of parents taking out home equity loans for college. The reason is that for most of us one of the best financial moves we can make is to enter our retirement years without a mortgage (or at least a minimal mortgage). This way the home is a critical part of our financial safety net.

In sharp contrast, your daughter has a lifetime of earnings ahead of her. It makes more sense for her to borrow for her education, and for you to help her out along the way (perhaps even after she's graduated) so that she doesn't end up with too much debt.

06/03/08 by Chris Farrell

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529 Plans

Question: My husband and I had our first child in February. Our budget has us paying off our student loans and credit card debt in the next 16 months. We'd like to put the money we currently spend on our student loans ($500 a month) and place it in a 529 fund for our daughter once both debts are paid off. I've seen a lot references to 529s, but was wondering if you could recommend some sources that provided guidance on how we can review the various states' 529 plans and their pros and cons. By the way, we plan on spending the money we've budgeted monthly on paying off the credit card debt to restore our savings as I stayed home on unpaid FMLA to care for our daughter after utilizing all my paid sick leave from work. We were able to finance the unpaid leave from our savings, which also depleted it (but was well worth it). Jennifer, Spring, TX

Answer: What a good use of savings. You had the money to do something important for your family. Bravo. The reason I'm posting this question is that your approach toward debt-and-savings is one I highly recommend: Pay down the debt, and when it's extinguished keep on setting aside the same amount of money into savings. It's a sound strategy for replenishing and building up savings.

The best resource for learning more about 529 college savings plans is at www.savingforcollege.com. It offers a good overview section for free. You will have to pay a modest price to get access to the detailed information. Check it out.

06/09/08 by Chris Farrell

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July 1, 2008 and Student Loans

Question: I'd like to first start off by saying I love show and could listen to it for 3 hours a day if it were on and I had the time. Honestly, how can someone like Chris know so much about such a wide range of financial topics? I've heard a lot recently about the July 1st deadline to consolidate students loans to a very, very low rate and was wondering: 1) What personal information do I need to gather? and 2) What website should I go to.

I usually am at work when the show is on, so I only get to listen to bits and pieces, but an e-mail or any response would be greatly appreciated. Thank you! Wade. Duluth,MN

Answer: I'm glad you enjoy the show. On the student loan front, there's no need to rush. However, anyone with variable rate student loans should mark July 1 on their calendar. If you consolidate after that date you can lock in interest rates 3 percentage points less than the current 7.22%. That's a huge savings over the life of a loan. So, if you're thinking of consolidating, wait. The student loan consolidation market has shrunk with the credit crunch. Hopefully, it will open up again soon.

What's more, on July 1 the clock starts ticking on the new federal program that forgives remaining federal student loan debt after 10 years if you make all your payments on time and work for the government, non-profit, or other qualifying job.

A nice summary of what will happen on July I, 2008 is on the website Project on Student Debt at www.projectonstudentdebt.org. The specific page is http://projectonstudentdebt.org/july1-2008.vp.html.

06/27/08 by Chris Farrell

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