Parents borrowing for college put retirement savings at risk
Despite repeated messages in recent years that every parent’s primary obligation should be to save more for retirement, the “college at any cost” dynamic remains alarmingly entrenched in many American households.
Through the end of September, the total tab for federal college loans taken by parents was $98 billion, a 44 percent increase in five years. During that stretch, the number of borrowers who took out federal parent PLUS loans grew from 3.1 million to 3.5 million.
And for many older borrowers, we’re not talking small sums. The government reports that 870,000 borrowers who are at least 50 years old have remaining balances of $100,000 or more.
In a deep dive of its own database of student borrowers, Fidelity says that the aggregate value of college loans owed by baby boomers grew 33 percent last year, with the average balance hovering at $75,000 and the average monthly repayment tab above $700. (Some of that may be their own old school loans, but it stands to reason much of it is borrowing for their kids.)
Given that household budgets are pretty much a zero-sum game (what you spend on X is money you don’t have to spend on Y), something has to give. And for many households, retirement savings draws the short end of the straw. The Transamerica Center for Retirement Studies says median retirement savings for boomers is less than $150,000. That’s far short of what is needed when broken down into an annual withdrawal rate that could last 25 to 30 years of retirement.
Yet putting retirement ahead of the child’s is no one’s idea of easy. A do-anything-for-a-kid’s-wellbeing mindset is all but hardwired into many parental brains. And if there’s one thing behavioral finance has taught us the past few decades, it’s that we are not hardwired to think about the future when making hard decisions today.
It’s a dangerously short-sighted approach that can imperil the financial security of parents and, ultimately, their children. Before one dollar is borrowed for college, it’s important to time-travel to when you are 65, 75, 85. Are you confident you will have the money you want to live without financial stress in retirement?
If you hesitated for even a nanosecond, any thought of taking out federal PLUS loans to help pay for a child’s college costs should be reconsidered.
The dollar you don’t borrow is a dollar you can be socking away for retirement. That’s not shortchanging your kids. It’s lowering the probability they will need to help support you in a few decades. That’s the tradeoff here: If financing college impedes retirement savings, it ups the odds you may need to lean on your children down the line.
One example. The interest rate charged on a parent PLUS loan is set each year. For the current academic year, the fixed rate is 5.3 percent (and there’s a stiff 4.228 percent origination fee.) Let’s say you borrow $18,000 this year. Repaying the loan in 10 years (the standard) will require a $150 monthly payment. Not so bad, right? Well, that’s just for the freshman year. What’s your plan for the next three years?
Even if we assume that interest rates will not go up, and that you borrow the same sum for sophomore, junior and senior years (to be clear, borrowing tends to go up, not down), you’re looking at a monthly tab starting in year four of $600 to cover all four loans.
And that $600 will be owed for six years, after which the freshman year loan will be repaid, and you “only” have three PLUS loans left to repay.
Let’s say that $600 monthly cost hits at age 56 and runs through age 61. If that requires reducing your retirement contributions by $600 a month, that works out to $43,200 for just those six years. Because you’re near retirement, and because of today’s low bond yields, let’s plug in a somewhat conservative 4 percent annualized rate of return. That gets you to about $49,000 in foregone retirement savings for just those six years. If that money were left growing until you reach 75 it would be worth more than $88,000.
The far better strategy is to forgo borrowing for college, or keep it limited so you can continue to save for retirement.
And for the record, your child should always borrow first. Federal student loans have a lower interest rate, and chances are your child’s initial post-school income will likely mean qualifying for the federal student loan interest deduction.