Those who understand how the financial system works and position their assets and financial strategies accordingly can net themselves tens of thousands of dollars more over the course of a typical four-year college education. When I was working as a financial advisor, one new client I counseled was a single self-employed woman in her fifties who was making about $30,000 per year. When her daughter applied to college, this single mom, who owned a quite modest home and had about $100,000 in savings, never had her daughter apply for aid. My client believed she would not be deemed financially needy.
When I reviewed her financial situation, I was struck that she had no money earmarked or saved in retirement accounts. She decided to contribute a chunk of her savings into an annuity and was surprised to hear me say that she should have her daughter apply for aid. She was even more surprised when she got about one-third of her daughterís college costs paid for with grants and when she qualified for low-interest loans.
While some people have learned the tricks for how to get more student financial aid, most people Iíve worked with and heard from over the years donít understand how the system works. This financial aid illiteracy is due in part to advice in the mass media and elsewhere. Since well before the early 1990s, when I began working as a self-employed, hourly-based financial planner, I have been a voracious reader of personal financial advice in the media and elsewhere. While some guidance is a matter of personal philosophy or beliefs, other advice was either right or wrong.
One column that got under my skin discussed the virtues of paying down your home mortgage. The piece focused upon how much money you could supposedly save in interest charges by paying off your mortgage faster. I wrote a detailed rebuttal to the columnist highlighting that he had failed to consider the alternative uses for the extra cash in his examples used to pay down a home mortgage. By overlooking funding a retirement account, for example, he had overlooked some terrific tax savings, as most such accounts featured up-front federal and state income tax savings. Also problematic was the fact that using extra cash to pay down your mortgage instead of funding retirement accounts can reduce a familyís financial aid award.
Over the years, Iíve read many mortgage advice columns advocating paying down oneís mortgage to save tens (if not hundreds) of thousands in interest dollars. Entire books have been written on the subject, such as ďThe Bankerís Secret.Ē Nearly all overlook the financial aid impact of building more equity in your home rather than ďhidingĒ your money in retirement accounts.
I say hiding because from the perspective of how most colleges and universities award financial aid, thatís what it is. When I first learned that higher education institutions did not consider retirement accounts when determining aid, I was incredulous. I have never conducted nor seen a formal survey quantifying how many people donít know that stashing money in retirement accounts essentially hides it for purposes of financial aid analysis. However, I can say confidently that the vast majority of people I encountered as a financial planner and now as a personal finance writer donít know this and many other basic facts of the financial aid system. And thatís a major problem that leads to some big inequities.
Whenever I have written columns explaining how the financial aid system works and how folks can legally qualify for more aid, Iíve gotten some pretty nasty mail questioning my ethics and morals. While I have relatively thick skin, the criticism hurts some. I know that I am trying to teach people how to get more aid. And Iím also well aware that those who know and understand how the game is played will get more aid, in some cases much more, than those who are in the dark. That is terribly unfair, since those charged with the responsibility of heading the financial aid programs fail to explain the current rules. Even if they did, the system is poorly designed and needs a major makeover.
To see how unfair the current financial aid system is, consider $100,000 in each of the following types of accounts or assets: a parentís retirement account, a parentís regular taxable (non-retirement) account, in home equity, or in a childís name. >From the standpoint of financial aid, most people donít realize that the worst place to have that $100,000 is in the childís name because that could knock up to $35,000 off of the applying studentís first year aid package. (While the way schools treat them is still evolving, money placed into the newer Educational Savings Accounts and 529 plans can have a similar deleterious effect on financial aid packages). That same $100,000 in a parentís taxable account would cause just $6,000 to be shaved off of the annual aid awarded. Put that same $100,000 in a parentís retirement account and no aid would be lost due to that asset. Schools utilizing the federal financial aid methodology ignore home equity, whereas some schools, mostly private, consider home equity a parental asset similar to a taxable investment account. Thus, children of those parents who work at paying off their mortgage faster are penalized with less financial aid.
Well-intentioned parents all across America want to save to put their kids through college. So when a new child is born, the parentsí and relativesí typical reaction is to open up a savings or investment account in the childís name and make some contributions. Parents who neglect saving for their own retirement so they can fund their childrenís college accounts really get whacked when they apply for financial aid, only to find they have insufficient money saved to finance their retirement.
The first obvious change that should be made in the system is to treat all parental financial assets reasonably equally. Stashing money into retirement accounts should not provide a loophole. Consider two different families that have identical situations (including annual incomes), except that one family has one million dollars invested in retirement accounts whereas the other family has one million dollars in non-retirement investments (rental real estate, stocks, bonds, etc.). With the current system, the first family fares far better in the financial aid game.
The financial aid methodology should recognize that most people do need to save toward their retirement and should allow families to set aside as off limits for financial aid calculations a certain amount of assets for retirement, regardless of whether that money is inside or outside of retirement accounts. The trick will be in accounting for other valuable assets such as earned pension benefits. For example, a government employee who has vested 30 years in a pension may be able to retire on that pension and have less or little ďneed,Ē from a retirement planning standpoint, for additional investments. Itís a relatively simple matter for financial wizards to assign a lump sum value to a future stream of pension benefits. The challenge will be to persuade people to honestly disclose all such valuable assets.
Another important issue that needs addressing with the current system is this: Few allowances are made for differences in the cost of living for families who reside in areas with significantly higher housing and other costs. On paper, a family applying from Palo Alto, California, owning a $500,000 home and with a family income of $80,000 seems far more affluent and able to pay big college bills than a family in Nebraska owning a $200,000 home with a $60,000 annual income. But what if the Nebraska family owns a new 3,000-square-foot home and is saving a significant portion of their annual income thanks to the lower cost of living in the Cornhusker State? Suppose further that the Palo Alto family owns a 1,200-square-foot bungalow and is able to save little of their annual income due to the high costs of living in the San Francisco Bay Area. Now, which family is more deserving of aid? A small number of the more competitive admission institutions do make some allowance for cost of living differences but usually not enough.
Regardless of what changes are enacted in the financial aid system to make it fairer, the rules of the game should be clearly explained to everyone who applies to colleges and universities. When a consumer goes to buy a home, for example, certain disclosures of closing costs are required. Why canít we mandate disclosure to all families that student financial aid exists and how qualifying for it is determined?
Everyone should know and be informed regarding:
- What types of assets are allowed and which are penalized by the system and by how much,
- The value of students applying to college without major concern about costs since aid packages can fill gaps,
- How borrowing for college is ďgood debtĒ and represents an investment in the studentís future; only the truly affluent can afford to pay for college by themselves,
- First-generation college students have additional aid available exclusively for them,
- That there is value in families discussing shortfalls in financial aid packages with financial aid officers who may be able to offer a better package.
No matter what changes are proposed to overhaul the financial aid methodology, there will be objections and concerns about the challenges of implementing those changes. No system is perfect. However, we owe it to all higher education applicants and their families to level the playing field and to make sure aid goes to those most truly in financial need and not those with the most astute advisors.
Eric Tyson is a syndicated columnist and author of Personal Finance for Dummies, which won the Benjamin Franklin Award for Best Business Book of the Year. He is a former personal finance counselor.