Before you sign up, you have to figure out how you’re going to pay for college each year. The first step in figuring that out is confirming with the school what has to happen for your aid package to be renewed. Then, consider the additional costs that aren’t included in the award letter—travel to and from school, activities your student intends to participate in, spending money. With all of those items written down, you have a good sense of what you’ll actually spend each year. This may seem really elementary, but most cases of extreme debt I’ve seen originate to some degree from underestimating the total cost of college.
Most families use a combination of savings, cash flow and borrowing to pay for college. The other big culprit in extreme debt situations: deferring payment on student loans and allowing interest to accrue and capitalize. That’s why your cash flow planning needs to include the cash required to make loan payments during the school years.
You probably have a fairly good sense of your available savings and the cash you could put towards college on an annual basis. Many people assume that it’s best to spend savings until it’s gone and then start borrowing, but that’s often not the case. Each pot of money—savings, cash flow and loans—has its own benefits and drawbacks, so combining all three each year tends to be advantageous.
Paying out of pocket makes you eligible for federal education tax breaks. Depending on your income level, $4,000 or $10,000 in out-of-pocket education expenses can qualify for the either the AOTC, the LLC, or the tuition and fees deduction. Check the IRS’ website for details on which of these you might qualify for. Remember that you cannot take these deductions for expenses paid from a 529 plan account—they need to be paid from cash flow.
The best loan to take out is the federal direct student loan. It has the best interest rates, a portion may be subsidized (no interest accrues during school years), it has all the federal student loan protections, and the student is more likely than the parent to be eligible for the student loan interest tax deduction given its relatively low income cap. If you will be borrowing, start with this loan. The annual limit on the federal direct student loan for a first-year undergraduate student is $5,500.
Here’s a quick trick: Divide your college savings by 4. Add your annual cash flow available to pay for college. Add $5,500 (the direct student loan amount). That’s what you might call your RFC, or Realistic Family Contribution. Is that equal to or greater than your first year’s cost? If so, congratulations, you’ve chosen a school you can afford.
If your RFC is less than the cost of college, warning bells should be going off. Each year, you’ll add two costs: the cost of financing your existing loan balance and the cost of any aid that you lose. If you’re borrowing above the federal direct loan limits in the first year, you can expect that you’ll have difficulties making payments against those loans in subsequent years, and that payment is only going to increase over time.
Hi readers, this might be my last post for a few weeks, but I’ll be back.