July 14, 2013

Save for college? You do the math

If you scrimp and save toward your child's diploma, you'll end up shelling out far more than the parents who didn't.

By RICHARD VEDDER/Bloomberg News

Believe it or not, Americans used to save about one-tenth of their after-tax income. By the 1990s, that percentage had dropped to less than 5 percent, and from 2003 to 2012 the average savings rate had fallen even further.

click image to enlarge

click image to enlarge

We can point to many reasons for this decline. An important unrecognized culprit is the American university -- and not just because the costs of higher education have far exceeded inflation. Colleges impose a very high private penalty on savings, giving people incentive to consume rather than save. Moreover, this penalty -- call it a tax -- has grown substantially over time in a stealth fashion with rising college attendance, soaring tuition charges and more aggressive tuition discounting by colleges.

First, let's look at the general savings numbers. I examined government data on the personal savings rate over the past 50 years, taking decennial average rates. (Annual data are often overly influenced by the business cycle.) In the period encompassing mostly the 1960s and 1970s, the savings rate was in the 9 percent to 10 percent range. From 2003 to 2012, by contrast, the average savings rate was a paltry 3.8 percent. While international comparisons are a bit tricky for various technical reasons, the latest Organization for Economic Cooperation and Development data I have seen show that the European Union had a notably higher average savings rate than that of the United States.

People save because they expect their financial outlays to exceed their income at some point, necessitating drawing on accumulated assets or borrowing. The big three items requiring savings are: income for retirement, the purchase of a home and payment of college expenses.

Because people are living longer, the motive to save for retirement has actually increased, so that doesn't explain falling savings. Indeed, low savings have caused some older Americans with high health-care costs to lose all their assets. Nor do any fundamental changes in housing markets account for the reduced savings. On the contrary, as house sizes have expanded along with housing prices over the years, the motive to save enough for a home has increased.

But college degrees have become the new educational norm, and tuition costs have soared over the past generation, more than doubling in real terms, rising far faster than family incomes. The possibility of financing school through parents' belt-tightening during the college years, along with student employment, simply isn't doable now for most. But why borrow, via student loans, rather than save in anticipation of that expense? The colleges brutally punish those who go the savings route.

Consider two young people who have identical potential for success in college based on high school grades, test scores and so on. Let's say both are accepted at an upscale private school costing $50,000 a year, or $200,000 for four years. Both kids come from moderately prosperous families with $125,000 in annual income. Student A comes from a family that saved a lot for college by scrimping, buying a modest $200,000 house and paying it off. This family has managed to accumulate $100,000 to defray much of their child's college costs.

Student B comes from a big-spending family that has a $350,000 house with a big mortgage, and a vacation condo and nice cars, all bought with borrowed money. This family has no college savings account as a consequence.

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