Family Debt Management: Should You Take Out a Student Loan for College or Save Up and Pay With Cash?

05/24/2012
By
Loan

Loan (Photo credit: Philip Taylor PT)

I’m not a believer in the idea that debt is evil. When managed correctly, debt is very useful, it can help you save money and get you ahead in your finances. To prove my point, we’ll take a look at two decisions that young adults face; take out loans to pay for college or work first, save money and pay for school out of pocket.

The Costs of College, Income and Loans

Young adults do not face easy choices when it comes to college.

College is pricey. According to the Department of Education the average tuition for public school is $12,804. It’s only getting more expensive and quick. Bloomberg reports that the rate of tuition increases was at 8.3% last year.

However, the potential payout is impressive. College graduates earn an average starting salary of $38,950 compared to high school graduates who start at $21,500. College graduates are less likely to be unemployed.

Taking out student loans isn’t an easy financial decision either. Student loans are tax deductible and government loans have low interest rates; currently at 3.8%. However, they are also unforgiveable, meaning you can’t discharge them in bankruptcy. Once you sign on the dotted line, the debt is yours until it’s paid off.

Take Out Student Loans or Save Until You Have the Money

It’s time to put the “debt is evil” belief to the test. Who will make out the more money at the end of college? One of our test subjects will put his whole education on student loans and another ficticous person will work and save up the full cost of tuition before going?

Cost and Income to the Student Loan Debtor

I hope our first college student knows what he is getting into. Starting out with an average tuition of $12,804 and an annual inflation rate of 8.3%, our debtor will pay $57,952.54 in tuition and capitalize an additional $1,716.14 in interest based on the government rate of 3.8%.

Our student then selects the extended repayment plan at graduation. This adds an additional $27,325.33 in interest payments over the next 20 years. However, given the tax deductibility of student loans, our debtor saves $4,098.80 in taxes. Overall, the evil college loans and tuition costs $82,895.21.

Cost and Income to the Student Saver

No interest payments for our saver student. Instead of racking up unforgivable loans, the student saver is going to go straight to work and save 65% of his salary for college. That means an annual payment of $13,975 for college.

However, each year the saver saves for college, tuition becomes more expensive. In fact, even with investing his savings at a 5% interest rate, it takes 8 years to save up. By then, the cost of college is $109,673.10 for the next four years. That’s $26,777.89 more than what was paid by the student taking out student loans.

The Debtor Also Earns a Lot More Income

The saver not only pays more money for college, he’ll lose out big on earning income as well. If it takes him 8 years to, he’ll have earned $191,185.22 before taxes and assuming a 3% pay increase every year. The debtor will earn $298452.90, using all the same assumptions, by the time the saver student graduates.

The point of this is not to encourage people to take out massive amounts of student loans to go to college. However, using loans to fund a smart college education that leads to a good career is an excellent use of debt and a perfect example of why debt isn’t evil.

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9 Responses to Family Debt Management: Should You Take Out a Student Loan for College or Save Up and Pay With Cash?

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