What if I were to tell you that savings and loans are identical bookends? You're skeptical but hear me out. They're mirror images of each other. Sort of like twins: one is right-handed, and the other is left-handed. But they're very similar: they're both payment plans you can use to your advantage.
Think of savings and loans as two financing techniques generally reserved for making a special purchase. Maybe it's a new car, or a big vacation, or a new home. Or a college education. Savings are the pre-college bookend, a payment before the purchase. College itself is the book between the bookends, and loans are the post-college bookend, a payment after the purchase. While the sequencing is reversed, the elements are the same.
Let's define a savings plan. It's an arrangement to set aside funds every month in installments before making that special purchase - a purchase too large to squeeze into your monthly cashflow budget.
In this arrangement you place funds in a savings account each month and earn interest on a growing balance. You're paying yourself. The cashflow here is negative because the funds deposited aren't available to you for other uses. Funds are released only to pay for college.
And now a loan plan. It's an arrangement to set aside funds every month in installments after making that special purchase. Again, a purchase too large to squeeze into your monthly cashflow budget.
In this arrangement you place funds with the lender each month and pay interest on a declining balance. You're paying a lender. Just as above, your cashflow is negative because the funds paid aren't available to you for other uses. Funds are released only to pay for college.
Savings and loans work well together. If you only use the savings technique, you place stress on the family cashflow budget before college. And if you only use the loan technique, you place stress on the family cashflow budget after college.
By using them together, whether 50%-50% or some other ratio, you lessen the stress on both the before and the after college cashflow budgets. The more you save, the less you need to borrow. And vice versa.
Let's keep it simple. Let's say you're facing a $30,000 annual cost of education (tuition and fees, room and board, books and supplies, personal expenses and transportation). Options include a savings plan earning 3.00% interest a year, compounded monthly for 15 years, and a loan plan charging 6.00% simple interest a year for 15 years.
The chart below shows how much you need to save and/or borrow, depending upon how you combine the two plans.
- If you save all $30,000 before enrolling, you'll need to save $131.85 each month.
- If you borrow the entire $30,000, you'll repay $253.16 each month after college.
- If you split the cost evenly between savings and loans, you'll need to save $65.93 each month before college, and you'll repay $126.58 each month after college.
By combining both savings and loans you lower both the amounts needed to be saved up front, as well as the amount to be repaid at back end. Can you feel the financial stress lifting?
The tradeoff, of course, is a longer combined payment plan. Can you change the ratio from 50% savings and 50% loan to 75%-25%? If you can save more every month, do it. The more you rely on savings, the less you'll rely on loans.
Your takeaway should be to fear neither a savings plan nor a loan plan. Both are there to help you achieve your goal of paying for college. Find the balance point between the two. It's different for every family. The greater your ability to save, the lesser your need to borrow. And vice versa.
And the sooner you start saving, the better. A longer savings period reduces the required monthly deposit, while also taking advantage of compounding interest. More on that in a separate posting.
To come full circle, when you save, you're really part of a loan plan. You're lending money to your credit union, and it's paying you interest in exchange for the privilege of using your money. A loan plan is the same thing, with the parties reversed. The credit union is letting you use its money, and you're paying it interest for the privilege.
Or think of it this way. In a savings plan, you're paying yourself each month. In a loan plan, you're paying the lender. Remember I told you up top that they're twins?
Just be careful with your debt. Keep track of what you're borrowing and never take out more loan than you can handle. Before you borrow understand how that loan translates into monthly payments and understand how those monthly payments fit into your monthly budget, given the income you anticipate earning. More on this in a separate posting.