2 College Finance Conundrums Clarified

With those college acceptance letters starting to roll in and the stark reality that college tuition, books, supplies and housing are “imminent financial threats” for families with high school seniors poised for higher education this fall (or summer for some), now is a great time to address some enduring financial and investment questions.

Here are a few great questions I’ve been asked of late regarding college finances:

Q: Should you raid your retirement fund to pay for junior’s college costs?

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A: Saving for retirement and paying for your child’s college are two major expenses that parents face throughout their financial lives. The top priority here should be making sure you are saving enough for retirement. You can always borrow money to help pay for your children’s education, but if you are not set up properly for retirement, as it approaches you may have to work during years you envisioned sitting on the beach or playing golf.

To fully understand this picture you must have a full understanding of your financial picture. This includes understanding your income and expenses to see if you can pay for college and save for retirement. If you decide to forgo investing for retirement to pay for college, you must think about the effects it will have on your cash flow in retirement. I would never recommend pulling from retirement accounts to pay for college, because the penalties can be detrimental to your financial life. Not only will you have to pay income tax on the money you pull out of many retirement accounts, but you may be faced with a 10% penalty if you are younger than 59½ years old. Many people are scared to borrow that money for college, but often times it is the best option.

If you borrow money at a rate of 5% to pay for school, can keep your retirement in place and have it grow at 8% to 10%, then you are in a far better situation than had you pulled from the account and paid heavy penalties.

Q: When is it smart for college students to buy rather than rent housing?

A: Buying vs. renting for college students may sound like a great investment idea, but it is important to think about many of the potential risks. Many investors feel comfortable with real estate due to its tangible nature, but over the last 20 years homes on average have appreciated by just 3.4% year. Compare this to the average growth of the S&P 500 at 8.2% per year and you are left with a large opportunity cost. This is due to investors leaving out the many costs associated with real estate. This includes property taxes, interest expenses, closing costs, remodels, repairs and maintenance on the home.

Think about the opportunity cost of investing in the home. Had you made a down payment of $60,000 and the home investment appreciated at the average of 3.4%, after four years your investment would be worth $68,585. Compare this to an investment that earns on average 8% and your investment would be worth $81,629. Many people also seem to forget the large crash we saw in real estate. In October 2005 the average price for a single-family home peaked at $275,938. This peak was followed by a large downturn and a long road to recovery. Fast-forward to November 2016 and the average price of a single family home has climbed above the 2005 level, but not by much: It’s just $282,341.

When buying where your child is going to school, your investment time frame may not allow for much growth. If your child is only there for three to four years, there is not much time for appreciation. This also does not factor in the risk of having your child wanting to transfer after just one to two years at a particular school. Plus, if your child leaves that school and the real estate market is having a down year, you may have to sell your home when it is underwater. If this is the case, you may consider renting the property to other college students once your child graduates. A problem with this scenario, is if you live far away there will be travel costs to make sure the property is being properly maintained, or you may have to hire a property manager, which could eat into profits. Also, college students can be a challenging group to rent to. There may be high turnover and costly expenses from having poor tenants.

For the investment returns to be favorable for homes, the rent expense would need to be more than double the costs associated with the home over the life of the investment. This is based on the return of 3.4% for homes and 8.2% for the S&P 500. These real estate expenses can also include large repairs such as a roof caving in, flooding expenses, etc. These can eat into months of rent income. The costs of buying and then selling the home can also add up.

Renting may seem expensive, but it provides an easy option with no risk.