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Don't Sabotage Retirement to Pay for College

Parental loans are a last resort--and maybe not even that.

Christine Benz, 07/27/2012

Given the flagging job prospects for new college grads, as well as the soaring higher-education costs, it's only natural that families are paying attention to the payoff potential of various schools and degrees. Unless money is no object, it just doesn't add up to pay $50,000 a year for college for a child who ultimately wants to pursue a low-paying career path. That helps explain the trend of high school graduates spending two years at lower-cost community colleges before transferring to four-year colleges to earn their degrees.

That more families are conducting a cost-benefit analysis of college is long overdue, and it could help to put some downward pressure on skyrocketing tuition rates. At the same time, few can dispute the value of a college degree. The economic downturn has put downward pressure on salaries, but even recent data point to college grads earning about $600,000 more over their lifetimes than those who graduated from high school only. Given that differential, it's no wonder that sending kids to school is a key priority in so many families.

But by multitasking as so many parents do--saving for college and their own retirement at the same time--they run the risk of coming up light on the retirement front with no way to make up for the shortfall, except for working longer. The old saying about this topic is dead-on: A child can get a loan to pay for his or her college education, but no one will give the parents a loan to pay for retirement if it turns out they haven't saved enough. Given increasing rates of longevity, rising health-care costs, and what many expect will be only so-so returns from the stock and bond markets in the decades ahead, can anyone ever really be sure they'll have enough money on which to retire?

Parents can undermine their retirements in favor of college in several different ways. The most benign is to steer a disproportionate share of their savings to college that they should have earmarked for their retirement accounts instead. Pulling money from 401(k)s and IRAs is an even more direct way of giving short shrift to retirement.

Yet one method of paying for school stands out as especially unhealthy: parental loans. With college costs rising and other sources of college funding, such as investment accounts and home equity, at a low ebb, it's easy to see why the loans have jumped in popularity. Many parents probably reckon that if their kids are also taking out loans, a parental loan is a way to share the burden, or to make up the difference if student loans, scholarship, and financial aid fall short. Parent Loans for Undergraduate Students, or PLUS, have generous limits, allowing parents to borrow enough to pay for any college costs not covered by the student's financial aid package. The interest rate on Parent PLUS loans, at 7.9%, also beats the rates available on many private student loans; it's also lower than the previous rate of 8.5% that was available for parent loans under the Federal Family Education Loan program.

And at first blush, taking out a loan to pay for your child's college costs might seem less taboo than raiding your own retirement account or tapping home equity. But it's next to impossible to think of a situation when a parental loan will trump other alternatives. And if a parent loan is the only option left, it's probably wise to investigate a more affordable college plan.

Here are some of the key reasons why parents should be practically allergic to taking out loans to pay for school.

Federal Student Loans Are Cheaper
Although many parents are rightfully unhappy with the idea of hobbling their children with debt, families who can demonstrate financial need and qualify for a subsidized Stafford or Perkins loan will almost always be better off going that route than opting for a Parent PLUS loan.

As a result of recent Congressional action, the interest rates on subsidized Stafford loans will stay at 3.4% for one more year; the rates on Perkins loans are capped at 5.0%. Both are lower than the rate on Parent PLUS loans. And the fact that both loan types are subsidized means that interest won't begin accruing as long as the student is in school at least half-time or can demonstrate financial hardship, such as being unemployed for up to three years. Because PLUS loans are unsubsidized, interest begins racking up from the time the money is disbursed, adding to overall borrowing costs.

Even families who cannot qualify for subsidized loans will be better with unsubsidized Stafford loans than Parent PLUS loans. The rate on unsubsidized Stafford loans is 6.8% or less, rather than 7.9% for the Parent PLUS loans. Despite the advantages of federal student loans over parent loans, however, college-funding guru Mark Kantrowitz notes on his website finaid.org that roughly one third of the families with Parent PLUS loans have borrowed less than the maximum from the Stafford program. Kantrowitz points out that even if student loan debt is in the child's name, there's nothing stopping parents from paying it down if they choose to do so.

More Costly Than Other Forms of Borrowing
Even if a family has taken full advantage of federal student loans in the child's own name, Parent PLUS loans fall behind other forms of borrowing in the desirability queue, too. Borrowing from a 401(k) or home equity line of credit, while not necessarily advisable, will still make more sense than parental loans in most instances. With 401(k) loans, the big drawbacks include: they must be paid back on an abbreviated schedule, often ranging from one to five years; they must be paid off in full if you leave your employer; and your loan amount is limited to the lesser of $50,000 or one half of your plan balance. The big positives, however, are more favorable interest rates--usually the prime rate (currently 3.25%) plus 1 percentage point--and the fact that you're paying interest to yourself rather than to a third party.

Borrowing from home equity also trumps parent loans on most fronts. Although they're variable, interest rates on home equity lines of credit, or HELOCs, are substantially lower than the Parent PLUS loan rate of 7.9%; plus, HELOC holders who are using the money for expenses other than home improvements--as is the case with college funders--can deduct up to $100,000 in interest. (HELOC interest is not deductible for filers who are subject to the Alternative Minimum Tax.) Of course, borrowing against the equity in a home, as with borrowing against a 401(k), isn't to be taken lightly. Variable HELOC rates could pop up, and borrowers could lose their homes if they fall behind on their payments. But for those with substantial equity in their homes, a HELOC will be cheaper than a parental loan.

Servicing Debt Costs More Than Invested Assets Can Earn
Some parents might rationalize borrowing to pay for college because it seems better than pulling money from retirement accounts. But that might not be the case. For starters, any investments in your retirement account will have trouble to generate earnings that can match the 7.9% rate you're paying on the parent loan. Pulling money from a Roth IRA is especially easy to recommend as an alternative to parental borrowing, as contributions can be withdrawn free of tax and penalty for any reason. Early withdrawals from traditional IRAs and 401(k)s are less advisable because the distributed amounts will be taxed, but it's possible to at least circumvent the 10% early-withdrawal penalty if the money is used to pay college tuition.

Questionable Job Market
Last but not least, some parents might rationalize taking out loans to pay for college with the expectation--or even the promise--that their kids will pay them back. That could work out just fine, but even children with the best of intentions might have trouble finding a job after college. And when their children do find gainful employment, parents might be hesitant to accept payment given that their kids are just getting their sea legs in adulthood by setting up their own homes, pursuing advanced degrees, or starting families.

Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz and on Facebook.

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