As more families start to recognize the severity of the student loan crisis and the danger of student debt, more and more are taking steps to avoid student loans. While this trend is mainly positive, some families may be taking things a bit too far. I’ve heard from several students and parents who were considering emptying their savings account to pay for school so that they could avoid student loans.
On the one hand, the whole point of saving for college is to have the necessary funds to pay for school. Money in a savings account is lucky to get 1% interest while student loans charge considerably more. At first glance, draining the savings account to pay for college tuition seems like an easy call.
However, there are limited circumstances where opting for a student loan might make the most sense.
Having an Emergency Fund Could Be More Important than Avoiding Student Loans
Student loans are bad, but some forms of debt are even worse.
Every year, Americans resort to high-interest credit card debt and payday loans to handle a financial emergency. When this happens, an unexpected home or auto repair becomes significantly worse.
If you are a 19-year old college student without responsibilities or obligations, no savings may not be an issue. If you have a spouse and kids, an empty bank account is dangerous. The appropriate size of an emergency fund will depend upon many different circumstances. However, having some money set aside for an emergency is critical in financial planning.
Not All Student Loans Are Created Equal
Draining your savings account to avoid a high-interest private student loan might make sense. Loans of this nature have the potential to spiral out of control. A bit of desperation to avoid a bad loan is logical.
However, the same desperation shouldn’t apply to a subsidized federal student loan. During college, the government is paying the interest. After college, there are options for student loan forgiveness and repayment plans based upon income.
If you are weighing the risk of dipping into savings against a student loan, the student loan terms are a critical consideration.
Most Important: Think About the Big Picture
Many students and families make the mistake of thinking about college costs one semester or one year at a time. I tell families they should focus on a bigger picture: the cost of the degree.
This big picture approach should influence many college finance decisions, including the choice between using savings or borrowing student loans.
If you are one semester away from graduation, avoiding additional student loans could be smart move. If you are in your first year of college, keeping that money set aside for later expenses may be the best choice. What happens if get to your final year and can’t find student loans or your scholarship runs out?
Put together a plan to pay for the degree. Federal student loans have strict borrowing limits for undergraduate students. If student loans will be necessary to pay for school, students should strive to minimize private loan borrowing. If you empty your bank account in the first year, you may end up with more private loans than necessary.
Do the Math When Deciding on Using Savings vs. Borrowing Student Loans
The math of the situation is pretty simple.
Suppose you are considering a $5,000 student loan at 6% interest. If we multiple the interest rate by the loan size, we get the yearly interest the loan generates. (.06 x $5,000 = $300). In this example, opting for a student loan would cost the borrower approximately $300 per year. If the money in savings is earning interest, the cost drops slightly.
Think of that $300 per year as an insurance policy. You are spending $300 per year to have that money stay in your bank account. Is it worth $300 to keep that cash on hand? How much are you willing to pay to have money set aside for a rainy day?
Final Thought: Don’t Overcorrect
An aversion to student debt is smart. The student loan crisis is real, and many graduates regret their borrowing decisions.
However, excessive student debt isn’t the only financial mistake that a college student can make. Don’t avoid a bad decision by making an even worse decision. In some cases, the smart choice might be leaving some money in your savings account for a rainy day and using a student loan to cover some educational costs.