Whew! Your son or daughter is finally safe and sound in their college dorm room with
the new loft you helped build, new roommate and all the excitement that goes with a new
phase in their life. Now you can relax! Really?
More likely, now begins a period of many worries. How will he or she get along with their
roommate? How will next semester’s tuition be paid? Will they get involved
romantically? Will they flunk out? Will they drink too much or get into trouble. Will they
rack up huge debt?
While there are many things to worry about, it’s highly probable that they will graduate
with a significant amount of debt. According to Nellie Mae, a student loan provider
located in Braintree, Massachusetts, a typical college student accumulates $20,000 in
debt by the time they graduate. On average, at least 15% of that debt will be owed on
credit cards. It’s not unusual for college students to have four or more credit cards!
According to NACE (the National Association of Colleges and Employers), starting
salaries for liberal arts graduates in 2007 averaged $31,333. Business majors
averaged in the $ 40,000 -$50,000 range and engineers between $ 50,000 and $
60,000. Let’s assume your student graduates, gets a $ 40,000 a year job and has the
average $20,000 in debt.
Assuming a he or she can pay off that debt at an interest rate of 7.5%, it will cost them
$237 per month to pay off a $ 20,000 debt in 10 years. Although a $237 a month
payment is clearly doable for a new grad making $ 40,000 a year, the real problem is
how such debts impact other life goals.
One of the first things a new graduate should think about is establishing an emergency
fund. Three to six months of living expenses are highly recommended. This could
easily amount to $ 10,000 to $ 20,000. Without an emergency fund in place,
unforeseen expenses are usually covered by racking up more credit card debt, in effect
digging a deeper hole to get out of. The sooner an emergency fund is in place, the
better. If possible, a new grad should allocate several hundred dollars a month to this
important goal. That can be tough to do while paying rent, making a car payment and
paying off that college debt!
If their new employer has a 401(K) plan with a matching contribution, they’ll want to
contribute at least enough to get the full employer contribution. That’s not important you
say ---- they can just wait a few years to start saving. At 7.5% interest, $ 200 savings a
month starting at age 25 will amount to $ 406,152 by age 60. If savings are delayed
until age 30, the amount accumulated will be just over $ 269,000, or more than
$135,000 less than had they started to save at age 25!
And what about buying a starter home? Everyone knows it’s better to own a home than
to pay rent. However, will your grad be able to afford to do so? First, they need a
sizable down payment to avoid costly PMI (Private Mortgage Insurance) and avoid the
risks of not having equity in your home. Then they need to worry about their credit
rating and debt guidelines. If they’ve been carrying high credit card debt and have not
been prompt with their monthly credit card payments, they may not be able to get a
mortgage.
Until recently, getting a mortgage has been pretty easy. Now with the recent “sub-prime”
mortgage crisis, lenders are tightening their guidelines. A typical “rule of thumb” is that
total debt (Mortgage principle, interest, taxes and insurance, credit card payments,
student loan payments, etc.) should not exceed 36% of monthly gross income. If we
assume a starter home costs $ 125,000, at a 7.5% mortgage interest rate, Principle,
interest, taxes and insurance can easily amount to $ 1,100 a month. Add on a $ 300 to
$ 400 car and car insurance payment and student debt payment of $ 200+, and you can
quickly see that total debt can easily amount to $1,600 to $ 1,700 or more a month,
substantially more than 36% of the monthly gross income of $ 1,200 for the $ 40,000 a
year graduate starting salary.
So what can your college student do to avoid debt? There are a number of possibilities.
Here are just a few ideas: (1) Consider getting a part-time job. The added income will
help meet needs and with less time on their hands, they’ll probably spend less. (2)
Consider a debit card instead of a credit card. Knowing that expenditures come right
out of their bank account will help control spending. (3) If they must have a credit card,
avoid signing up for more than one and keep the credit limit low. Having multiple credit
cards is asking for trouble. (4) Pack a lunch and avoid costly lattes at the coffee house.
(5) Buy used textbooks.
In a recent article in the Wall Street Journal titled “Keeping Your Financial Footing at 22,
So You Can Buy That House at 32”, columnist Jonathan Clements, noted that annual
college borrowing is up 85% over the last five years. Clearly, a significant amount of
college borrowing is due to the rapidly rising cost of tuition and room and board. Never
the less, credit card debt is also rising. In the same article, Clements noted that among
those graduates with debt, 34% had to sell possessions to make ends meet.
If you haven’t had a discussion about money with your new college student, make it a
priority. And even if you have, you might want to send them a copy of this article. The
less debt they rack up at school, the easier it will be for them to achieve their other life
goals.
David C. Patterson, CFP® and Erin Patterson, CFP® are the owners of Patterson Advisors, LLC, a fee-
for-service-only financial advisory firm. Patterson Advisors, LLC is a Registered Investment Advisor,
registered with the State of Michigan, helping clients in Waterford, Clarkston and Royal Oak, Michigan
as well as other Oakland County, Michigan communities . Visit www.pattersonadvisorsllc.com for more
information or call 248-674-2108.
Published in the Oakland Insider, September, 2007
Off to College!
By David and Erin Patterson