Borrowing for College: Here's The Formula

If your child is considering borrowing money to go to college, here's a formula to help you determine what's reasonable.

First, don't rely on what the schools tell you about the amount of debt your child can afford. That's why more than half of all student loans aren't even being repaid. Students are borrowing more money than their future earnings can support.

Second, you have to think about this as a business decision and take the emotion out of the analysis. If you don't, your child will probably end up taking on too much debt.

From a business standpoint, if your child is going to borrow money to increase his or her future earnings capacity, how much does it make sense to borrow? To start, you need to have an estimate of how much money your child might earn in the future. You wouldn't advise someone to borrow money to start a business if you had no idea how much income that business would generate.

  • For instance, if your child wants to be a teacher, that has one earnings outlook. If he or she wants to be a banker, that has another. You wouldn't and shouldn't borrow the same amounts for these two professions.
So before your kids take on debt, help them figure out how much the average person earns after college for the degree your child is pursuing. I suggest looking at an estimate for earnings over the first 10 years in the profession that your child is pursuing. Trying to project beyond that is pure speculation. Projecting for 10 years is tough enough.
  • If your child has no idea what he or she wants to do, then I would low-ball their future earnings estimates. Otherwise, your child may end up borrowing more than he or she can afford to repay.
When you're calculating your estimates for earnings, it's wise to look at average earnings for the chosen career path, which can be a lot different than top earnings. While we all want to think that our kids will be top earners in their fields, the reality is most people earn the average. And since you can't estimate with any degree of certainty where you child might end up in his or her profession, the average makes more sense from a business standpoint.

Once you have your average annual earnings estimate, consider taking loans of no more than 75% of that annual figure. I call this the Education Debt to Average Earnings Ratio. At a ratio of 75% (or 0.75), the repayment obligation would be about 10% of your child's average earnings for those 10 years, which is manageable.

  • So let's assume your child wants to be an electrical engineer, and you figure that over her first 10 years in the business, she would earn an average of about $60,000 a year. Thus, she shouldn't take on more than $45,000 of loans, which is 75% of the average annual wage. If you have to repay that $45,000 over 10 years, assuming an interest rate of 6.5%, that costs you about $510 a month, or $6,120 a year, which is about 10% of your average earnings.
  • Of course, all things being equal, the less debt, the better. But if your kids stay below 10% using a 10 year repayment schedule, then they can move on with the rest of their lives.
Unfortunately, too many students are graduating with debt repayments that consume far more than 10% of what they're earning. That is why so many young adults are defaulting on their loans.

Why do students borrow so much? Well, for the most part, students have no idea how much they might make in their jobs once they graduate. And then of course we have things like recessions that make it even harder. These are all good reasons why students need to take on less debt. It's just too hard to predict their future earnings, which of course lowers the economic value of the degree.

Colleges, however, would like students to think that higher earnings are automatic, and so a higher level of debt is justified. It's also why they're pushing for more government programs that will allow students to stay indebted for even longer.

For instance, the income based repayment programs that limit student loan payments to roughly 15% of future earnings are a good example. This is a great deal for the colleges. They can charge as much as your child can borrow, and have no responsibility for justifying the amount borrowed based on the income your child might earn after college. Yet, the repayments could last decades, so the student ends up indebted for most of their working career.

The college funding crisis is similar to the housing crisis. To help people afford higher and higher housing costs, lenders started making all sorts of non-traditional loans, which of course just created more demand for housing, and pushed prices higher. College financing is going down the same path. By distorting the financing, they create more loans to pay ever increasing tuition bills. The sad part is many students will be left holding the bag. They'll have lots of debt but they won't have the income to support the repayments.

Bottom line. College debt must be kept in proportion to the student's earnings capacity. Not enough kids understand this relationship, which is why so many are being burdened with life altering debt.

Learn More: Want to learn about more ratios that will help you manage your personal finances and prepare for retirement, investigate my new book Your Money Ratios: 8 Simple Tools For Financial Security, available in bookstores and at amazon.com The Wall Street Journal called the book "one of the best finance books to cross our desks this year." WSJ 12/19/09.