Planning for college cash flow can be tricky. It’s not just that the average public university costs over $25,000 per year whereas the average family has saved just over $18,000 total. There’s also the combination of tax credits and their attendant rules, a confusing menu of borrowing options, and misunderstandings about how aid formulas treat savings. Add multiple children with overlapping college years and it’s no wonder many parents throw up their hands in despair. One common theme I hear from parents is a version of, “We’ll just spend our savings until it’s gone and then borrow what we need.” This may or may not be the right answer.

Families who go into college knowing they’ll borrow at some point are often better off borrowing smaller amounts every year than waiting until the later years to borrow more, even if it means keeping money in a 529. There are two reasons for this:

  • Interest rates are lower on Direct Student Loans than on other loan options, but there is a limit to how much students can borrow annually under the program.
  • Families may be able to claim tax credits for all four years by spreading saving and borrowing out more evenly.

For example, consider a student attending an in-state public school for $25,000 annually, with $50,000 in savings in a 529 account. They could exhaust the 529 in the first two years and then use cash flow and borrowing to pay for the last two years. However, they would forgo $5,000 in American Opportunity Tax Credits for freshman and sophomore year because you can’t claim the AOTC for an expense paid by your 529.

Furthermore, they would have lost out on two years of Direct Student Loans ($5,500 for freshman year and $6,500 for sophomore year), replacing that $12,000 of loans at 5.05% interest (and potential subsidized interest during the school years) with Parent PLUS loans at a 7.6% interest rate. And, knowing that interest rates are likely to trend higher in the coming years while federal education loans have fixed interest rates, borrowing earlier is likely to save even more over four years.

Let’s say you took out $12,000 in direct student loans in your first two years of college and deferred payment on both loans until graduation. At the current 5.05% interest rate, your $5,500 freshman year loan would have a balance of $6,611 at graduation (due to accrued interest); your $6,500 sophomore year loan would have a balance of $7,484. On a 10-year repayment schedule, that loan balance would cost $149.84 monthly.

If instead you waited and borrowed that $12,000 under the Parent PLUS loan program in the last two years, those two would have a combined outstanding balance of $13,368 at graduation based on the current 7.6% interest rate, translating into a monthly payment of $159.38 because of the higher interest rate. Of course, it’s probably overly optimistic to assume that the interest rate will stay the same for the next two years since it’s tied to the 10-Year Treasury rate, which is likely to continue its upward trend over the next few years. (You could estimate that every 0.5% interest rate hike would add about $5 to the monthly payment.)

In this example, the family gave up $5,000 in tax credits to stave off borrowing for two years, and ended up with higher loan payments upon graduation anyway.

Of course this is a somewhat simplistic example, but you can play around with the cost of borrowing on Student Loan Hero’s Student Loan Deferment Calculator to see how this might pencil out in your own situation.