Saving for College? What’s the Present Value?

Bookshelf with Books

Congratulations!  You just found out you’re having a baby.  Better start saving for college now, because it’s expensive.  It’s going to cost you upwards of $50,000 in today’s dollars to put junior through college nearly two decades out.  Luckily, you’ve got a lot of time to dig yourself out of the hole and can take advantage of some great planning tools to lessen the burden.

I’ve created a college cost funding model that allows your to measure the present value of college costs against the present value of resources available to determine your current college funding surplus or deficit.  You can see an example and download a copy for yourself below.

Saving for College is Critical Because It’s Expensive

According to savingforcollege.com, the current annual cost of attendance for a 4-year public university (in-state tuition) is $24,061.  Over 4 years that’s nearly $100,000, and that’s the price today.  Tuition has generally outpaced inflation, consistently growing in the mid-single digit range.  Fast forward 18 years with 5% inflation and the total cost more than doubles.

If you want to go private, the cost is even more insane.  The current cost of attendance for a a 4-year private college averages $47,831.  Already that’s nearly $200,000 over 4 years.  Assuming the same 18 years of 5% inflation above and you’re looking at nearly half a million dollars!  Talk about sticker shock!

Public 4-Year (in-state tuition) Private 4-Year
Tuition $9,410 Tuition $32,405
Room & board $10,138 Room & board $11,516
Books & supplies $1,298 Books & supplies $1,249
Transportation $1,109 Transportation $1,033
Other expenses $2,106 Other expenses $1,628
Total $24,061 Total $47,831

But What About Financial Aid?

Luckily, financial aid is there to soften some of the blow.  A number of schools tout the fact that they will meet the full financial need of their students, meaning that whatever you can’t afford to pay, they will make up through a combination of loans, scholarships, grants, etc.  The problem is that you will likely have a different view of what you can afford than they do.

In general, you can expect that the higher your income and/or resources to pay for college, the less the school will be willing to give you.  But rarely will you ever being paying “full retail price.”

Present Value of Future College Expenditures

Despite college being expensive, if you have a little one it’s also pretty far out into the future and not nearly as expensive in present value terms.  The key inputs for determining the PV of future college expenses are as follows:

  1. Qualified college expenses (current).  These are the specific costs that you can use 529 funds to pay: tuition, room & board if living on campus and textbooks.  Numerous sources online allow you to identify costs for specific schools or the average for public/private colleges.
  2. Qualified college expenses (current).  Expenses you can’t use a 529 to pay for: transportation, off-campus living, pizza, etc.
  3. Years until the start of college and years in college.
  4. % of total costs to cover.  This one is a little tricky and it has a large impact on the ultimate results.  Since it’s unknown exactly where this will fall, I’d suggest testing out a range of options to see where you’re comfortable setting it.  The higher the number, the more conservative your results will be.
  5. Annual college cost increase %.  The cost of higher education has typically outpaced overall inflation, but not as quickly as investment returns.  For conservatism, assume that costs increase at the same percentage as your investment portfolio grows.

Present Value of Resources for College

Generally speaking, there are two resources to pay for college: money already saved (preferably in a 529) and the ability to save in the future.  Their growth is dependent on:

  1. 529 earnings % returns.  The return you expect the 529 to generate over the relevant time period.  It’s also the rate we’ll use to discount future college cost obligations back to the present.  Note that for simplicity I’m not factoring in likely changes in allocation to a more conservative portfolio over time or taxes.
  2. Annual 529 contributions and % increase.  How much you will contribute annually to a 529 today and the growth rate in contributions over time.  Your ability to save has value, so it’s a resource to support the expenditures along with the current 529 balance.

Over time, the present value of future college costs will increase as the discounting impact is slowly eliminated by the passage of time.  The goal is to have your resources grow at a similar pace so that you end up with the same resources and expenditures when it’s time to start paying bills.

Note as well that one of your resources, the ability to save for the future, also is reduced by the passage of time.  In order to keep pace with the growing PV of expenditures, you need to turn hypothetical future savings into real savings in the form of a higher 529 balance.

Saving for College Example

Here is an example of how we can estimate the current college funding surplus/(deficit) on a present value basis.  Let’s say you’ve got a 2 year old today that’s going to attend a public college when they’re 18 and stay there for 4 years.  You estimate that you’ll be covering half the costs, with the balance made up by financial aid, etc.  Let’s assume you’ve already saved $10k in a 529 and will contribute an additional $2000 per year, increasing at 3%.  Lastly, assume that the cost of college and my 529 will both grow at 5% a year.

Saving for College, Model Assumptions

Saving for College, Model Summary Results
As you can see, 4 years of college 16 years from now will cost a total of $226k, of which you’ll cover $113k.  Discounted back to the present at a 5% rate yields a total present value of expenditures of $48k.  While in this example you only have $10k in a 529 today, the funding gap isn’t $38k since there is value in your ability to save for the next 16 years.  That is worth $32k today, leaving you with a shortfall of only $6k.  Fully three-quarters of the resources you have today come from the ability to remain disciplined and save over the course of time.

Resource and Expenditure Present Values Over Time

Saving for College, Resources over Time

While present value of future savings makes up three-quarters of resources at year 0, it slowly declines over time as college approaches.  That decline must be offset by growth in the 529 balance, which it is in this example.  The combination of savings and market returns ultimately grows the 529 balance over time.  The decline in years 16-19 is when that balance is liquidated to pay for college costs.

Saving for College, Expenditures over time

Present value of future expenditures grows over time due to the discounting mentioned previously.  The more time until the expenses are due, the lower the present value.  Similar to the decline in resources in years 16-19, expenditures decline too as actual college expenses are paid.

Saving for College, Funding Surplus Deficit

Combining the two graphs shows how resources and expenditures grow with one another over time.  The $6k funding deficit in this example remains pretty consistent over time as well.  What this means is if you can tweak your assumptions to perfectly match current resources and expenditures today, it should stay pretty close to in balance over time if your assumptions are accurate.

Assumption Sensitivities

Lastly, let’s look at how changing certain assumptions impacts the current funding surplus/(deficit):

Saving for College, Cost of College Model Sensitivities

The assumptions selected can have a huge impact on the surplus or deficit.  Depending on which assumptions you choose, you can see what else you have to do to make the math work:

  • Increasing the annual savings contribution or the % growth in annual contribution grows surplus
  • Increasing earnings in the 529 earnings increases surplus while increasing the annual increase in the cost of college decreases the surplus
  • The higher the percentage of the total cost you will pay decreases the surplus

None of the inputs work in isolation, so you would have to adjust all of them to find the right mix for you and your specific situation.

Download the PVF College Cost Funding Model

You can download the PVF College Cost Funding Model that I used to create the charts and graphs above.  Populate with your own assumptions to see how well you are able to cover future college costs on a present value basis and revisit those assumptions down the road to make sure you’re still on track.

What Else Can You Do?

Fund a 529 before the baby is born.  You can get a 529 for anyone, including yourself.  The IRS let’s you change beneficiaries without tax consequences as long as it’s within your immediate family.  If you know you’re going to have a kid and that they are going to go to college, there’s nothing preventing you from opening a 529 in your name today, making contributions, then changing the beneficiary to your child once born.  You’ll have a longer window to make contributions, more time for your investments to grow and preserve all your tax benefits along the way.

Take advantage of a 529’s tax savings.  529’s allow you grow your money tax-free and withdraw it tax-free as long as it’s used for qualified educational expenses.  Sometimes you can deduct contributions from your state income tax return (not federal) or even get a tax credit for contributing.  Those benefits make a 529 a no brainer relative to a taxable account.

Beware of over-funding.  Too much of a good thing can still cause you problems.  A number of 529s cap the total value that can be in the account; pierce that limit and you can’t contribute anymore.  The more realistic problem is that you end up with money in the account after paying the final college bill.  If you don’t have another dependent to transfer it to, the money’s stuck there unless you pay the penalty.  That’s exactly what you were trying to avoid!

Conclusion

College is expensive, but paying for it isn’t insurmountable if you have a plan and start saving early.  By discounting the future cost of college and including your future savings potential, even multi-hundred thousand dollar bills can be brought down to size.  You may just find out you’re doing better than you think.

John started Present Value Finance in 2017 to share his experiences and insights on personal finance to help people make better decisions and take control of their financial lives.  

He achieved financial independence in 2016 by walking away from the high stress world of corporate finance to focus on his family. He’s a husband, father, family CFO, and all around finance geek.

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