When it comes to paying for your children’s university education, most parents want to help their children start off right by helping them with their student debt. This might be by co-signing a private loan, or taking out a Parent Plus loan.
One study showed that parents took on between $20,000 and $40,000 of student debt. Many of them dipped into retirement funds (and incurred early withdrawal penalties) to help pay this back. The result is parents at retirement age who not only have a smaller nest egg to retire on, but are on the hook for a lot of debt as well.
Why Pay Yourself First Works
Although it does not seem intuitive, the better solution is to pay yourself first (by investing it in your retirement fund) before you pay your children’s obligations. The reason is that through compounding of gains, your own account will grow faster over time which will provide you with more funds later to pay back loans than it will if you use the funds now.
Let’s take a look at a graph of what compounding means. The horizontal is time and the vertical represents the total value of a theoretical account. The red line represents the simple interest, which means it is the same every year. Compounding means that the interest paid in the next year is based on the total of the year before, which is a higher number.
The key point is that if you notice the red line goes up faster the more time passes. That means if you wait longer before using some of it, it will be a higher number to start with. Here’s a specific example.
Say you started at age 25 saving $2,500 per year until you were 65. We’ll assume 8% growth each year in this account. Your retirement would be worth $768,000 at age 65. But if you paid that $2,500 per year toward loans from age 45 to 65 (for a total of $52,500) rather than into retirement, your retirement would only be worth $621,000 at age 65.
As you can see from the graph, the loss of adding that money to retirement results in a retirement value $137,000 less. Had you paid yourself first, you could pay the child $52,500 out of your retirement at age 65 and still have $137,000 minus $52,500 or $84,500 more in retirement!
Alternatives to Taking on Major Debt for School
Instead of short-changing your own retirement, work with your children on alternatives. Limit university costs to start with if possible. Perhaps they can do a combination of a two-year community and two 2 years at university for a lower total cost. Perhaps they can attend an in-state school instead of an out-of-state school.
After graduation, when it is time to start paying back, perhaps help them with a percentage of the monthly payment and not all of it, and let your percentage decrease as the child earns more and is able to take on more of the total themselves. Also, keep in mind that some college loans can be forgiven after a period of payback, which is another reason to pay yourself first rather than the child’s obligations.
The bottom line is to pay yourself first and don’t let your children’s debt be your debt. Instead, wait until your nest egg has increased in value and then assist later in life, not earlier.