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Preparing to Pay for College
by Gary Foreman
gary@stretcher.com
How much money would I have to put aside in one lump sum to compound in interest enough to put my 6 month old son through college?
-- Jill A.
Jill sure packs a lot of question into one sentence! And beyond congratulating her on that new son, we also need to commend her for starting to think of college while Junior is still young. This year about 3.7 million of our children will turn 18. You can't help but wonder how many parents prepared financially so that college was an option for their kids.
Let's look at some information before we dig into the question. According to the College Board tuition and fees rose about 4 percent in the last year. The trend in college costs has been upward for decades. In fact, over the last 18 years (1980 to 1998) the cost of a public four year degree increased by 107%.
One consideration for Jill is where Junior will go to school. If plans call for a private four year university she'd be paying $14,508 (tuition and fees) plus $5,765 (room and board) for each of the four years. As you'd expect a four year public school is less costly ($3,111 plus $4,358). Cheaper still is the two year public college at $1,567 which assumes student lives with their parents.
For this illustration, we'll assume that she plans for him to enroll in a four year public school. She would expect to spend about $7,469 per year ($3,111 plus $4,358) or $29,876 over the four years. But here's the catch. That's in today's dollars.
There's no reason to believe that we won't continue to see prices increase for college until Junior's ready to start eighteen years from now. So let's answer Jill's original question. If she wants to put a lump sum away for his education, she should set about $30,000 aside. Why so much? Because the hope is that she'll be able to earn enough each year to offset the amount that prices go up.
But, what happens if we can't afford to plunk down $30,000 today? Is there a way to estimate how much you need to save each year?
There are a couple of different ways to calculate it. If you have internet access, the simplest way is to use a rate calculator.
Even if you've never touched a computer, there are ways to come up with a reasonable estimate. We considered a savings plan that would accumulate $60,000 over 18 years. Why a goal of $60,000? If costs have increased 107% over the last 18 years, a 100% increase from today's $30,000 seemed like a reasonable guess.
A 10% annual return was assumed. To accomplish our goal you'd need to make an annual contribution of $1320 every year.
If you were following this plan, you would have saved about $8,000 in the first five years. That's about 13% of our goal. By the end of year ten, you'd have saved $21,000 which is about one third of the way. After fifteen years, you'd reach $42,000 or 70% of the goal.
You'll notice that the rate of accumulation increases in the later years. That's compounding working in your favor. Another good reason for Jill to start early.
We've been working with some pretty rough estimates here. And there's a reason for that. Frankly, this type of projection is really too hard for pencil and paper calculation. If you prefer something more precise than what we've been doing and you don't have access to the internet, you'll need to buy a financial function calculator. They're inexpensive (about $20) and you can learn to use them in about one hour. Once you've gotten familiar with it, you can run all kinds of assumptions and get precise answers.
The proper way to analyze this question is to break it into two separate steps. The first starts with today's college costs and your estimate of the rate of price increase. That's used to calculate the cost in the years that Junior will actually be in college. That will give you the goal to shoot for. Don't forget to multiply by the number of years that Junior will be in college.
Then you decide how much you feel you can earn on your investments. Using the goal from step one and your expected rate of return the calculator will determine the annual or monthly contribution that will be necessary.
Your assumptions will make a great deal of difference. For instance, we assumed a little less than the 4% inflation rate on college costs that's held true for the last 18 years. We also assumed that we could earn 10% on our savings. But if we change our expectation to an 8% return on our savings, we'd need to increase our annual contribution from $1320 to $1600.
Obviously, none of us can see clearly 18 years into the future. The smart thing to do is to start saving early. Then every year or so, do a little math and adjust for any changes in the cost of college or your actual earning experience. If you do this every year you'll find that you'll be making minor corrections to the amount you save each year. Waiting can mean large adjustments when you have a short period of time to recover.
Again, we'd like to congratulate Jill for the new addition to her family and her foresight. Hope that little guy brings home good report cards for many years to come. I wonder if there's a "my honor student" bumper sticker in her future?
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Gary Foreman is a former financial planner and purchasing manager who currently edits The Dollar Stretcher.com website and newsletters. You can also follow Gary on Twitter or on his blog.
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