This post has a lot of words and a lot of numbers. Long-form story short: a college education is still worth a lot, but how you buy it now matters as much as the education itself. A minority of enlightened individuals can still escape the gravity of salary securitization. What's that, you ask? Well, I just can't say in short-form.

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Meet Emily. Just born. Imagine her 30-year-old parents holding her in their arms for the first time in the delivery room. They look at a clock on the wall and make note of the time of birth.

Amid the emotions in that moment, another clock starts running. Emily's first tuition payment is due.

If Emily's parents want to fully fund the cost of a basic four-year in-state college education out of pocket, they will need to save over $531 per month—every month—from the instant Emily is born until the final year of her college experience. That's 21 total years of making a $531 monthly payment, every month, for 252 months straight.

If college tuition and related costs maintain their current trajectory, the full cost of Emily’s four-year college experience 18 years from now will be over $217,000.1 Emily’s parents aren’t an investment bank or an institutional investor. They can’t raise capital on a whim or engage in sophisticated asset-liability matching strategies to hedge the future cost of college.

If Emily's parents want to pay for her college education, they have but one option: slash their monthly take-home pay early and often.

But Emily's parents face other recurring expenses—some new, some old. They probably have a mortgage. They may be paying on decade-old student loans or credit cards. If Emily attends a child care facility, the monthly cost of that could easily exceed $531. Emily's parents are also about to experience the receipt-shock of buying impossibly numerous and expensive things for the baby that they never knew existed. And if coming into parenthood, Emily's parents are above-average savers, they are putting away at least $531 for their own retirement.

The chances that Emily's parents are even aware of the cost of college at her birth are slim. The chances that they are thinking about how much to save or actually doing it from Emily's birth are even smaller.

But the implicit decision not to begin pre-funding Emily's college education immediately will have a profound impact on Emily's life. Guaranteeing that Emily will go to college won't be enough to give her freedom. How college is paid for may matter more.

College is still worth it

A few timestamps back I made a post that asked a rather rhetorical question:

What net value are universities adding to society if middle class graduates face an adult life enslaved to lenders?

That was the wrong question. A little too loaded. There are two opposing, gargantuan dynamics at play inside that question: the benefits of college versus the cost of college.

A better question to start with is: "what value does a college education add?" The answer to that question is undoubtedly "a lot."

A 2013 report released by the College Board indicates that overwhelmingly college graduates earn more than those with only a high school degree. I think it's fair to at least question whether an organization like the College Board would be biased in their reporting of such statistics, but the numbers are so lopsided in favor of getting a college education that I don't think it's worth coming up with conspiracy theories to counter the notion that a newborn like Emily—someone whose future ambitions can't possibly be known for many years—is statistically more likely to have a better future life with a college education. And that's whether you measure her betterment in terms of earnings, enlightenment, or social mobility.

I absolutely believe that with each passing year, it's possible to do anything with just an internet connection and a ton of ambition, but simply hoping a child will fall into that mold isn't a savings substitute. It's an avoidance strategy that will only increase the chances that someone else will have to front the cost of her education—someone the child will be shackled to for most, if not all, of her adult life.

For now, access to conventional college education still means going through conventional universities, whose costs, in my opinion, are getting crazier and crazier thanks in large part to runaway public funding and student loan credit. More on this in a moment.

As a parent, I have no ability to immediately reform university administration. I can't control Congress's appetite for extending student loan credit. You can't either. So I think we should take a practical approach.

Because of soaring college costs, it's absolutely critical to do long-term planning and establish habits very early to take control of how you pay for college.

As I'm about to demonstrate, saving for college, though a seemingly impossible moon shot, is by far the most financially rational way to pay for a child's future college education. And perhaps ironically, I also believe that saving for college is the best way to help a child realize her full entrepreneurial potential even if she ends up not needing her degree. That's because because every dollar of pre-funded college education is several dollars of student loan debt avoided. Saving for college is now a substantial form of early inheritance.

But before I show you some numbers, it's worth understanding how we got here.

A brief history of student loans

Federal student loans have gone through several incarnations since falling out of the National Defense Education Act of 1958, one of the most immediate American responses to the launch of Sputnik the year before. In 1957, the Soviet Union had beaten the U.S. to space, and America needed more scientists if it was going to catch up, much less win, the space race that would consume the country for the next two decades.

Because of the NDEA and other things, college attendance did indeed rise, and eleven years later the air around American living room TV sets vibrated with the words "that's one small step for man..."

While typical Americans eventually lost interest in the space program, they did not lose their appetite for student loans. Through several iterations and partnerships with banks in the decades the followed, the federal government directly and indirectly boosted student lending even more.

Today, the balance of student loans in the U.S. is an astronomical $1.2 trillion, nearly all of it federally backed. Student loans are now the second largest form of consumer debt behind mortgages.

From American dreams to monthly payments

It's impossible to escape the temptation to compare student loan payments to mortgage payments. Both are methods of post-funding "American dreams" using either direct federal funds or rely heavily on federal guarantees. Both are highly profitable and "too big to (let) fail". Both represent a de facto securitization of middle class salaries by a blend of federal agencies and Wall Street.

At least a mortgagor can sell their home in a healthy housing market to extinguish mortgage debt. The security backing student loans isn't so liquid: the salary of the college graduate. This asset, too, can be sold, but only in installments of time for decades.

Multi-trillion dollar Freddie Mac and Fannie Mae (federally backed mortgage agencies) are more profitable today than before the financial crisis when they were clinically dead and needed life support from the federal government.

When it comes to student loans, college graduates have proven to be a fantastic investment for the federal government—and I don't necessarily mean in a social sense. Student loans have relatively tiny default rates, and loan rates more than cover the federal government's cost of funds, allowing the government to debatably run the programs at a profit that rivals the Exxon Mobils and Apples of today.

College grads do indeed earn more statistically, but that's not enough. It's not even enough to make more than it costs to pay back student loans. People who post-fund college education will be pressured to maintain fixed salaries to align their income with the debt payment outflows they pledged to pay.

I'll say more about the social implications of this at the end. Let's look at some numbers now.

Post-funding vs. pre-funding

Back to Emily. Let's look at two extremes for funding her college education:

  1. A pre-funding strategy: Her parents save and pay for 100% of her college
  2. A post-funding strategy: Her parents save nothing and Emily borrows 100% of the cost

The pre-funding strategy

Saving for college has an opportunity cost. Every dollar saved for Emily's college education is a dollar not used for some other purpose. There are infinitely many actual "paths" those not-saved dollars could travel, but for the sake of quantifying the impact on long-term net worth, I think it makes sense to think about the cost of pre-funding college in terms of Emily's parents' lost retirement wealth.

If Emily's parents deposit $531 per month into a 529 plan that earns an average annual rate of 5% per year, it will fully fund the $217,000 total cost of Emily's four-year college education.

Emily’s parents’ retirement accounts (401(k)s, IRAs, etc.), by contrast, could earn something higher—something more like a long-term net stock return of 7%.2 This is because at age 30, Emily’s parents’ retirement is much farther off than Emily’s college education, so retirement savings can be exposed to more market risk.

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As the 529 plan balance grows, so too does Emily's parents' forgone retirement savings. If Emily's parents committed the same $531 per month to their retirement savings, the balance would be worth more than $317,000 at the time Emily graduates from college. From there (totally untouched), it would accrue to over $764,000 by the time Emily's parents turn 65.

This is the ultimate cost to Emily's parents for paying for Emily's college education in advance. Sacrificing $764,000 of future wealth is a lot, but as we will see, it could be much worse for their daughter.

(Keep in mind this is just for one child attending a 4-year in-state university. Multiply by two for two kids. As for grad school, that's beyond the moon.)

The post-funding strategy

Assuming Emily is able to borrow the full $217,000 through some combination of federal and private loans, she will also get a college degree, but bundled with it will be a coupon book obligating her to pay $1,167 per month for the next 30 years of her life.3 That’s $755 in today’s dollars.

What would it mean to have $755 of after-tax pay spoken for in 2015? Well, for one, $755 would be the mortgage payment on a fully-financed $158,000 home at a 4% mortgage rate in 2015.

But of course, Emily isn't buying a house with that payment. She's repaying her educational debt. And to do that, she has only one choice: She must put her education to work in the "real world" and begin generating cash flow to match her student loan liability. Culturally, college licenses Emily to be a "knowledge worker." Economically, it's made her a leveraged bond owned by the federal government.

Regardless of how much Emily makes per month, one certainty will persist for 30 years: she'll be required to pay $1,167 every month. As with the pre-funding scenario where her parents lost the opportunity to do other things with the amount they saved per month, Emily's debt payment represents money that won't be used for other purposes.

Forfeiting $1,167 per month of disposable income could lead to infinitely many outcomes. It may cause Emily to go deeper in debt than she would have otherwise. For example, it could increase the likelihood that she carries credit card debt. It may also delay the purchase of her first home, missing the opportunity to build home equity. It’s impossible to quantify every scenario, so let’s focus on what I believe is one of the least Draconian outcomes. I’ll just assume that she’ll be able to put $1,167 less into her own retirement savings per month.4

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This let's us compare the long-term effect of pre-funding versus post-funding on intergenerational wealth. When Emily finally pays off that student loan balance at age 52, she'll have nearly $1.4 million less saved for her retirement. Left untouched from age 52 on, the balance would have grown to more than $3.3 million by the time she turned 65.

Summary of results

Another way to think about the loss of future retirement savings is in terms of the annual income those savings could generate in retirement. This is the basic purpose of retirement savings, after all.

Value at Retirement Value In 2015 Dollars
Parents’ retirement loss if they save for college 764,194 382,118
Equivalent 30-year annual income post-retirement 37,853 18,928
Emily’s retirement loss if she borrows 3,306,219 912,684
Equivalent 30-year annual income post-retirement 163,768 45,208

The $3.3 million Emily loses by borrowing is worth over $900,000 in today's dollars assuming a 2% annual inflation rate. In today's dollars, this amount of money could purchase a 30-year annuity at 3%, which would pay Emily over $45,000 per year for 30 years (age 65 to 95). Her parents' lost retirement income in today's dollars, by contrast, would only be about $19,000 per year.

Why are these outcomes so different?

The value of money doesn't stay "still" over time. The pre-funding and post-funding strategies are like two different universes for paying for college, and their respective values drift apart over time. There's a wide gulf between paying for something in advance (i.e. savings) versus paying for something in arrears (i.e. borrowing).

In the pre-funding scenario, Emily's parents own every penny of the investment gain, which is the shift in the time value of their savings. 100% of this gain goes to paying for college when those expenses come due. The reason that Emily is hurt so much more by borrowing is that a lot of the student loan payment is made up of interest. In other words, the lender owns the change in the time value of college education—long after the education actually occurs.

Think of it this way: By waiting to borrow, the actual cost will not only inflate for the next 18–21 years, it will continue to inflate for decades beyond that—like a growing snowball tumbling through the generations, smashing opportunities and freedoms in its path. If Emily borrows to pay for college, what hope do her kids have? Their kids?

Saving in advance stops the snowball. 5

The social impact

The 20th century is long gone. Today, it makes a lot less sense to say "college isn't for everyone." We're in a knowledge worker's world now. If college education becomes so costly that it suffocates all but the very wealthy with debt, I think it will have lasting harmful effects on American society. The two that concern me the most are:

  1. People will increasingly make what they think are financially rational choices by selecting college programs that maximize earnings potential. College students pressured to do this will be more likely to neglect liberal arts education, and I think this is a massive cultural misstep that's not only bad for society as a whole but also individuals. Even though it seems like technological progress requires more and more technical skills, I think people who understand the nature of people by understanding history, art, and literature will have a tremendous advantage over their otherwise peers. No amount of math, scientific, or programming ability is a substitute for understanding human nature.
  2. I think that if federal and state governments continue to tacitly encourage the bureaucratic expansion of university administrations through direct public funding and a limitless supply of student loan credit, it will produce a class of salaried workers with little opportunity to ever gain real financial independence.

Of these two, the second is the most disturbing.

Meet the pass-throughs

I cannot overstate how profoundly different the mindsets and perceived freedoms are between someone who owes a fixed payment indefinitely and someone who does not. More than ever, the former is what defines middle class America. The intestine of the financial system, if you will, the middle class's role is not accumulate the fat of money, but rather to consume an increasing salary base and pass it back out in the form of consumption and debt payments.

The American way of life is one of paying indefinitely for things that happened in the past.

Federally-backed mortgage giants like Freddie Mac and Fannie Mae are designed create "structured securities" using the cash flows that boil up from the eternal spring of mortgage payment cash flows that American "homeowners" make monthly. Some of the simplest of these securities are called mortgage pass-throughs, which basically pass the cash flow arising from a pool of mortgages to investors who buy up various tranches (like slices of pie).

Mortgage securitization is like a multi-trillion dollar water mill that sends yields to institutional investors at the top and then dumps credit back into the financial system for more lending. It was the financial invention that largely made the Reagan-era housing American Dream possible. Mega quasi-federal institutions like Freddie and Fannie make mass mortgage culture possible, but they also can't exist without the massive supply of mortgages they create. It's very circular. Without the underlying mortgage cash flows, the water mill goes dry.

And without a stable spring of American middle class paychecks, there are no mortgage cash flows. In other words, the true collateral underlying the trillion-dollar mortgage-backed security market isn't really mortgages—it's the paychecks of the middle class.

Though many people confuse one for the other, income and wealth are very different things. A dog with a tapeworm eats more and more, but he does not get fatter.

The necessity to borrow for college will ensure that the middle class will continue to evolve into a "pass-through" socioeconomic class.

Pass-throughs will be the tenant farmers of publicly leveraged capitalism. They will spend most of their adult lives working to pay for the right to live on land that is, in economic reality, owned by the federally-backed landlords of Wall Street. Pass-throughs will earn what appears to be an attractive salary only to cede much of it to profitable federal student loan programs. Pass-throughs will thrive as long as they never stop—the next jerk of the leash will never be more than 30 days away.

Most pass-throughs will spend their unpledged disposable income on basic necessities and luxury items that they perceive to be necessary to maintain their "high-earner" social status—a total delusion with little-to-no actual wealth backing it.

If student loan credit continues to approach to mortgage-like levels, who will the middle class really work for? Surely not themselves.

There are of course other ways to avoid borrowing for college—scholarships, etc. But on the time scale required to pre-fund college for a child today, that's like betting it all on black with the risk of a lifetime in the red. The only way to hedge the risk of having to borrow is to save. It's that easy. But it's also that hard—few government-backed mechanisms exist to encourage saving beyond tax-sheltered 529 plans. It's on the American individual to commit to saving and take the market risk necessary to reach a finish line that's running away nearly as fast as we can run toward it.

To leverage my own sense of determination, I will borrow heavily from John F. Kennedy's 1962 moon speech, made right about the time the student loan debt pendulum was set in motion:

I choose to save for my kids' college, not because it's easy, but because it's hard. The challenge of helping my kids avoid student loan debt is one that I am willing to accept, one that I am unwilling to postpone, and one I intend to win.

If that sentiment sent a man to the moon, maybe it can send a kid out into the world debt-free. Even better, maybe it can propel them beyond the bounds of our social gravities—out into a socioeconomic universe that isn't dimensioned in monthly paychecks.

  1. If you play with online 529 plan calculators, you’ll likely get a different number than $217,000 (both higher and lower). The precise number that came out my calculations is $217,311. I came up with this by averaging the key assumptions from online calculators that project future college costs (e.g. here and here). I used an average of $23,000 for current annual college expenses, and projected that at 4.5%, an average college expense inflation rate. This results in $50,795, $53,081, $55,469, and $57,966 for years 18–21, respectively ($217,311 total). $531 is the level monthly payment required to accumulate a 529 plan at 5% that exactly “matures” for the four-year college cost liability. It assumes that each year’s college costs are withdrawn at the beginning of the college year (exhausting the savings at the beginning of year 21). I think 5% is a reasonable projected net annual return for a 529 plan, which will need to grade from a mostly-stock mix into a more conservative stock-bond mix over time. Some sites assume higher returns, but I personally think that’s overly wishful thinking for planning purposes, especially after accounting for fees embedded in 529 plan funds. Again, different inputs will result in different outputs, but I think these are very reasonable assumptions, and changing them a little here and there isn’t going to change any of the conclusions made here. ↩

  2. Different people will have different estimates for long-term investment performance, but I think 7% is a reasonable net long-term assumption. You can argue that the U.S. stock market returned higher average annual returns in the 20th century, but that was a very different world. More importantly, 7% is greater than the 5% assumed for the 529 plan, and I just think it’s logical to assume that a 529 plan will earn less than a long-term retirement account for any parent under 50.  ↩

  3. $1,167 payment assumes monthly payment for 30-years at 5% interest. Current federal student loan interest rates range from 4.29–6.21%. It’s impossible to know what student loan interest rates will be in the future, but they could definitely be much higher than 5%, which would make the monthly payment even higher than $1,167.  ↩

  4. Yes, some people will say “you can’t assume she would have saved that whole $1,167 every month.” And yes, that’s true. But again, the point is to quantify the blow to her net worth. As I said earlier, we can come up with even worse scenarios where the student loan payment causes her to carry more consumer debt, which would almost certainly have a higher interest rate than the 7% per year lost to forgone retirement savings. In the very worst scenario, her debts could exceed her assets resulting in bankruptcy. In that scenario, she’d have no retirement savings at all. (It’s worth noting that student loans are a rare breed of debt that can’t be disposed of during bankruptcy. Remember me saying student loans are a great investment for the federal government?) ↩

  5. By saving in advance using a 529 plan the growth is tax-free, meaning that 100% of the gain truly is available to pay for college. Some will argue that student loan interest is also tax-deductible, but that would only matter if Emily can itemize her deductions—something that would likely only happen if she also owns a home with a sizable mortgage interest outlay to deduct. But the student loan payments will make it even less likely that she will be able to afford a home anytime soon after graduation, so the deductibility of student loan interest is closer to wishful thinking than any kind of certainty.  ↩