I recently came across a calculator developed by Morningstar to help families estimate future college costs and to determine whether they are on track with saving to meet the future costs of higher education. Let’s have a look at what this tool can and cannot do and how such a tool may be useful.
The key variables that determine the future cost of a college education are:
(1) How many years remain until your son or daughter starts college
(2) Whether they will attend a public or private college
(3) How long they will remain in college, and
(4) Whether they will actually pay the “sticker price,” or receive financial aid, grants, scholarships (etc., etc.)
The Morningstar calculator assumes that your student will, in fact, be paying the full advertised cost of the average public or private university. This is a fairly large limitation to the utility of the tool all by itself. The average student does not pay the advertised price of attendance. In fact, the average student at a private four-year college or university actually pays -33% less than the advertised total tuition and fees.
At public schools, the discount is smaller, but substantial, at 18% less. Even students from families in the highest quarter (e.g. 75th percentile) of income received substantial discounts from the sticker price. There is increasing evidence that the advertised price (the ‘sticker price’) of attending an institution of higher education is considerably higher than most students pay. Higher ‘sticker price’ for college attendance may simply be a way for colleges to signal that they are desirable, with students actually ending up paying less when they attend. For an interesting summary of this issue, see the following piece titled, “College is Cheaper Than You Think,” by Judith Scott-Clayton at the NY Times Economix blog. But, for the moment let’s set this issue aside and move along in looking at Morningstar’s calculator.
The estimates of future college costs start with the current average advertised costs for 4-year private, 4-year public, and 2-year colleges. These figures are obtained from The College Board. If you are a parent who has not perused these numbers recently, these numbers may come as something of a shock. The average advertised cost of attending an in-state 4-year college is $19,388 per year. The next step in the calculator is the assumption that college costs will continue to rise at 7% per year, which is around the long-term average inflation rate determined by the College Board. The article by Judith Scott-Clayton cited above, suggests that the actual costs that students end up paying has not risen at all over the past five years and has actually declined slightly, so the 7% escalation rate may be thought of as a rough estimate.
So, on the cost side, the Morningstar calculator looks to be on the high side of what we might actually expect in terms of future college costs. What about on the savings and investing side?
The Morningstar calculator uses a simple return rate for savings prior to starting college and a second simple return rate during college. By ‘simple return rate’ I mean that the calculator assumes that you will get a fixed rate of return each year without consideration for taxes. For the pre-college years, the baseline assumption is that college savings will generate a 5% annual rate of return. Because the calculator ignores variability in returns from year to year, it is essentially assuming that you can find some way to get a risk-free 5% per year. This is an unrealistic assumption. There is, in fact, nothing close to a 5% return than can be achieved risk-free. Because of the use of a constant projected rate of return on invested college savings, the Morningstar calculator will tend to under-estimate the savings rate that will be needed to be able to generate the targeted level of savings with a high degree of confidence. There is also a drop-down menu that allows the user to select historical rates of return that are representative of standard asset classes (stocks, bonds, etc.) but the returns provided here are (according to a footnote) the net-of-inflation returns. The rate of escalation for college costs is in nominal dollars (not net of inflation), so there seems to be a mismatch here.
Ultimately, the estimated costs of college attendance generated by this calculator are probably too high, while the estimated returns that you can get on your college savings are also too high. These two errors will tend to cancel each other out, so that the estimated necessary savings rate to be able to fund college are probably pretty reasonable.
The current cost of a four-year degree in-state at a public university is around $80,000. This is a substantial sum of money and it is not surprising that the average college graduate who borrows to attend school now leaves school with $25,000 in debt. Given the high costs of a college education, calculators like the one provided by Morningstar, are valuable in helping parents and future college students decide how to weigh the costs and benefits of their college choices.
A range of commentary suggests that the growing prevalence of college-related debt has the potential to be the next great financial crisis in America. The ‘easy money’ decades that enabled the real estate bubble also allowed colleges to increase their tuition and fees at a much faster rate than inflation, by providing a ready stream of students who simply borrowed more to compete for slots in desirable schools. This debt-funded competition for education made only slightly more sense than the debt-funded bubble in real estate. For parents and potential students, running a calculation for the future costs of education will range from mildly shocking to downright terrifying. No matter the limitations with a calculator such as Morningstar’s, having a baseline estimate of the true costs of a college education can help to inform better choices.
The final and critical piece of any discussion of the total costs of going to college is examining what the payoff is for the student. The Morningstar calculator does not tackle this additional topic. While there is data that suggests that college graduates have vastly higher lifetime earnings, the proposition needs to be examined in terms of whether any person’s specific choice of college and major is a plausible match to their future earning power.