By Charlie Farrell, Special to The Denver Post
As high school seniors begin to think past graduation, the dreaded cost of college looms large. According to the New York Federal Reserve Bank, student loan debt has almost tripled over the last 12 years, leaving students confused and scared about how much to borrow for college.
Colleges are driving some of the confusion. They have little incentive to encourage students to borrow less. Sounds harsh, but it’s true. The more you can borrow, the more colleges can charge you for tuition and costs. High student debt fits nicely with the college institutional imperatives of expanding administration and student amenities.
Yet, sadly, it leaves many students with debts that are a huge burden to their financial independence. So how do you get a handle on the debt question? You have to consider only borrowing an amount that can be comfortably supported by your future earnings. That’s a lot different than borrowing for the cost of college, whatever that may be.
Linking borrowing to income is not a novel concept. It’s how you would go about borrowing money for any business venture, and college is a business venture. You’re spending money to improve your future earnings potential … that’s a business.
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Before you borrow, you need to estimate how much you’ll make from your venture. Only then can you figure out if you can support the debt payments. When most people hear this about college, they say, “I have no idea how much I’ll make.” And therein lies the problem. You’ve got to figure it out.
Today, there’s plenty of data on average earnings for folks in many different jobs and professions. If you are pursuing a degree in electrical engineering, I’d find out how much a new electrical engineer makes. You want to be an arborist? I’d check into that occupation’s pay. If you like teaching, I’d figure out those salaries.
If you have no idea what you want to do, then I’d look at average earnings for all college graduates and then consider that you’ll probably be in the lower half of that average earnings. Remember, half the people are above the average and half are below. If you don’t know what you want to do, then at least half the things you might do would pay below the average. If your goals change, then you can change your assumptions. But to start, I’d be more conservative.
Once you have an idea of the average earnings for graduates in your anticipated profession, add up what you think you’ll make in the first 10 years and divide by 10. This gives you your average earnings per year for the first 10 years. Then, multiply that number by 75 percent and consider this figure as your maximum borrowing. By following this formula, your annual loan payments will be about 10 percent of your annual salary for your first 10 years. If you’re the student struggling with the student loan question, or the parent trying to help your child decide on the appropriate loan amounts, it’s a good idea to follow this formula.
Here’s how it works. Let’s say you get an accounting degree and you figure out your starting salary is likely to be $50,000 per year, and you estimate it would increase by 4 percent per year for your first 10 years as a result of your increased skills. That adds up to $600,000 of total pay for 10 years, for a 10-year average of $60,000 and 75 percent of that number is $45,000. This is your maximum borrowing guideline.
If you borrow $45,000 and pay the loan off over 10 years at 6 percent interest, the payment is about $500 a month, or about 10 percent of your average monthly earnings of $5,000. That’s a reasonable repayment schedule for access to a higher-earning profession and hopefully many future years of opportunities to increase your income.
These ratios for college loans work with just about every salary level. If you think you’ll make $100,000 a year on average, then your maximum borrowing amount is about $75,000, which is a monthly payment of about $830, or around 10 percent of your average monthly income of $8,300.
The point is you must tie your borrowings to your anticipated earnings. It’s not hard, and if you learn this very basic concept, you’ll make smarter borrowing decisions for the rest of your life.
Charlie Farrell is a CEO of Northstar Investment Advisors LLC and guides the firm’s investment philosophy. He is the author of “Your Money Ratios: 8 Simple Tools for Financial Security.” This article is for information and education purposes only. It does not constitute investment, tax or legal advice.
