When IOUs Can Be A-OK
Perhaps it was a childhood spent watching her single mother struggle financially to raise kids.
Or perhaps it was her own experience having to scrimp and save to pay for college and law school. Whatever the reason, Russelle Holsinger doesn’t like debt. “I am real careful. I don’t want it,” says Holsinger, a real estate lawyer in Morris, Ill.
Though she knows that some debt is unavoidable–on her house and car, for example–Holsinger prefers to have saved the needed money before buying anything substantial. She shops with cash or a debit card. She’s even started saving for a Disney vacation for her family, determined to have every expense accounted for before entering the Magic Kindgom.
Holsinger and her husband have been able to parlay their fiscal responsibility into some respectable assets for a couple of their age, including an investment property, retirement accounts and substantial savings. She’s also mindful that in another 16 years, her 19-month-old baby will be on his way to college.
But Holsinger can’t quite get past the nearly six-figure law school debt that looms large over her head. Why, she questions, should she be planning for her retirement and her child’s college education when she could start chipping away at significant chunks of her student loans with the money she is earning?
Sure, it sounds reasonable, says Life Audit financial expert Tom Haunty, but it’s not. The reason is the ever-rising cost of college, he says–a cost that is rising 6 percent to 12 percent a year. At those rates, Holsinger will find herself more in the red if she borrows to pay for her son’s education because her disdain for debt forced her to invest less.
“She has a micro focus on debt costs, but in the big macro picture, the cost of college inflation is far greater than her debts,” he says. “She needs to reconsider her attitude about debt.”
Big Picture, Big Returns
To start, Holsinger needs to embrace the idea that not all debt is bad.
Rather, debt can be an effective financial tool, especially lately with loan interest rates at or near historic lows, Haunty counsels. By using debt and investing wisely, Holsinger has a greater chance of paying off her student loans and reaching her family’s future goals.
Because of the pressure she feels to pay off her student loans, Holsinger had been considering switching from a graduated loan repayment plan with a low 3.97 percent interest rate to a standard repayment plan. Under the standard plan, her monthly payments would be more than double the current one, but her debt would be retired faster.
Don’t go there, Haunty says. Holsinger needs to look at the bigger picture. Her student loans, while large in principal, are not costing her much because of the exceptionally low interest rate. “She is worrying about the 3.97 percent interest,” Haunty says. “The problem is that she’d rather pay off that low rate instead of starting to invest for her kid’s potentially higher-costing college education expenses.” Investing more and sooner for long-term potential growth is one important strategy for her to meet those rising education costs.
Holsinger also had considered a similar debt avoidance strategy for her house. She and her husband recently refinanced to a historically low-interest, 15-year loan with an eye toward paying it off as soon as possible. With the savings generated from the refinance and an earlier payoff, she reasoned, she would then have cash to start saving for her son’s education.
Because of her debt abhorrence, Holsinger has sunk in extra money each month, sometimes as much as $950, into her mortgage and her home equity line of credit.
“Stop doing it!” Haunty says. “She has already cut her debt costs by securing such low rates. Take the extra money and invest it in a 529 college savings plan instead. Paying off her debt early may guarantee her a low rate of return from the paid off interest, but that will most likely be below the return she needs to achieve her college funding goals.” (For more detailed information about 529 plans, see “College-Level Economics” in the February 2003 ABA Journal.)
Haunty advises Holsinger to sink her extra cash into a 529 college savings plan that invests in diversified stock- and bond-based accounts so that she can attempt to keep up with college cost inflation. A quick check of a college cost calculator shows that Holsinger needs to invest close to $500 a month to be able to pay 100 percent of one child’s college tuition in 20 years, assuming a current cost of $20,000 a year.
Haunty prefers 529 college savings plans for children’s educations over other financial instruments because of the favorable tax benefits and flexibility they offer. Because Holsinger wants to fund her young child’s college education, Haunty says she is on the right track. “The best advice is to start investing early and take appropriate risk to go for the opportunity for higher returns,” he says. “Although there are no guarantees, investing over a long-term time horizon can reduce the risk. Time and compounding are some of the best things you have going for you.”
Thomas A. Haunty
Thomas A. Haunty, CFP, REBC, is a senior associate with the North Star Resource Group in Madison, Wis.
He has provided financial assistance to lawyers and their clients since 1982.
Russelle L. Holsinger
POSITION Principal, Holsinger & Westover, Morris, Ill.
GOAL Prioritizing debts while saving for her son’s college education and planning for retirement.
Life Audit Hot Tip: Calculating College Costs
Want to see how much you really need to sock away for junior’s college tuition?
Log on to http://scooby.moneytree.com/asp/edufund.asp, plug in the numbers and see how you are doing so far. While many brokerage houses and banks offer similar online college cost predictors, Haunty prefers this site because the method of calculation is clear.
Whatever site you choose, Haunty says not to get depressed from the numbers. “It makes you think about how you are going to approach saving for college,” he says. “The longer time frame you have, the less risk there is. If I have a kid who is going to college in three years, am I going to put the money in the stock market? No. I cannot afford to make that bet. But if she is a newborn, then I am going to put my money in the stock market and mutual funds.”
Thinking debt is bad.
Overpaying on your mortgage.
Waiting to save for a child’s college education.
Learning to live with low interest debt like student loans and mortgages while erasing high interest loans like credit cards.
Investing extra money in a fund that yields a higher rate of return than the mortgage.
Investing money for college as soon as possible in a program such as a 529 savings plan.