Paying for College

Why You Still Need to Fund a College Education

If investing in a degree is like starting a business, then let's fund it that way: with equity instead of debt.

A fierce debate has erupted in America over the value of a college education. Passions are running high. "Education is a bubble in a classic sense," said Peter Thiel, Silicon Valley investor and co-founder of PayPal, in an interview with National Review. "People are not getting their money's worth, objectively, when you do the math."

His comments didn't go over well with William & Mary economists Robert B. Archibald and David H. Feldman, who said in an Inside Higher Ed article: "On average, most of us are average, and the data show that college is a very good investment for the average person."

The outcome of the dispute is critical to the health of the economy. In the meantime, parents and students have to figure out what to do. Taking a page from modern finance theory could offer parents and policymakers a practical way to make decisions.

But first, let's review some numbers that illustrate why college is becoming controversial.

The cost of earning a sheepskin is steep. According to the College Board, tuition and fees at a public four-year university for the 2011-12 academic year average $8,244 for an in-state student and $20,770 for an out-of-state student; the average price tag for a private nonprofit college is $28,500. And that's before you add in room, board, books, supplies, transportation and other expenses.

After taking inflation into account and adding in average charges, the four-year figures are $95,000, $151,000, and $187,000, respectively. (Yes, those are the average sticker prices, before taking into account discounts, grants, scholarships, saving money by living at home and other offsetting factors. Nevertheless, the price of attending a four-year college is dear.)

And college charges are spiraling upward. After adjusting for inflation, the tab for tuition and fees for an in-state student at a public college is 3.68 times higher than it was in 1981-82; tuition and fees at private nonprofit colleges are 2.81 times greater. Little wonder the cost-of-college calculator has a default inflation rate of 7%.

Then there's the debt side of the equation. Students and their parents are borrowing a lot of money to pay for college. According to the College Board, total borrowing to pay for an undergraduate degree jumped by 56% from the 2000-01 school year to the 2010-11 school year. To put those numbers in absolute dollar terms, total borrowing for college rose from $49.9 billion to $111.9 billion. Hard to imagine, but as late as 1993 most undergraduates didn't borrow for college. Now, two-thirds receive a student loan repayment book along with their college diploma.

What's more, incomes are squeezed. The typical household suffered a 7% drop in income over the past decade. Young college graduates fared even worse. The real earnings of male college grads ages 25 to 34 who hold only a B.A. are down 19% from a 2000 peak, according to Michael Mandel, chief economic strategist at the Progressive Policy Institute in Washington, D.C. The real earnings for young female college grads are down 16% since peaking in 2003.

Despite the negatives, however, a college education still pays off in the short run and, more important, over a lifetime.

More than 25 million Americans are either unemployed or involuntarily working part-time. But people with a college education are faring better than their less-educated peers. The unemployment rate for workers 25 years and older with a B.A. or higher is 4.4%; for those with some college or an associate's degree, it's 8.3%. The unemployment rate for those with only a high school diploma is 9.6%; for those with less than a high school education, it's 13.8%. (See more about educational payoffs in our slide show 5 Advanced Degrees Still Worth the Debt.)

And while incomes for young college graduates are down, they have cratered for less-educated workers in recent decades. For instance, the average recent college graduate earns about 70% more than the typical high school graduate, according to Michael Greenstone and Adam Looney of the Brookings Institution.

The scholars add that in 2010, a 50-year-old college graduate made $46,500 more, on average, than someone the same age with only a high school diploma. About three-fourths of jobs require some form of postsecondary education — with more than half of those jobs requiring that workers have a B.A. or higher, according to the Georgetown University Center on Education and the Workforce.

The Brookings scholars estimate the return on investing in college is 15.2% a year (they assume a total investment in college of $102,000). That's more than double the stock market's average return of 6.8% over the past 60 years (and it dwarfs the miserly 0.4% return on housing).

Here's the rub: It's an axiom of modern finance theory that the only way to create the opportunity to earn a higher return is to take greater risk.

Looked at your 401(k) statement recently? The market has gone through some horrendous bear markets — as well as breathtaking booms — along the way toward achieving its six-decade average annual return of 6.8%.

In other words, the numbers say that there is a lot of risk embedded in earning a college degree. Think of it this way: How many 19- and 20-year-olds really know what they want to do when they graduate? Your son or daughter may have started in the sciences (which might have led to a high-paying career) and ended up a history major (likely leading to a job with a small salary).

And while students might start college when the economy is booming, they might get their diploma during a recession. Jobs and careers are more volatile today than they were three decades ago, as corporate America has downsized, right-sized, restructured, reengineered and outsourced jobs in a hypercompetitive global economy. A low unemployment rate doesn't mean college graduates don't get laid off.

For policymakers, the volatility of earnings and careers suggests that it might be time to dust off the wisdom of the late Nobel laureate Milton Friedman. He argued in 1955 that investing in a college education was much like starting a new business: It's a risky enterprise with a high average expected return but wide variation around the average. That makes it the kind of investment that's best financed with equity rather than debt.

Few of us have the necessary equity, however, so here's a radical idea: Scrap the current financial-aid system and the expected parental contribution and replace it with a plan that lets students pay for their education out of their future paychecks rather than a family's current finances. The repayment for attending could be adjusted for inflation. It would be met out of future earnings, so that students who graduated into high-paying careers could retire the bill quickly, and those who entered low-paying fields would pay less. Any payments left after, say, 20 years would be forgiven. (Note that this proposal isn't a debt-financing scheme in disguise. There would be no chance of default or need to file for forbearance or deferment.).

Variations on this basic idea already exist. For example, Australia offers a program in which students don't pay university tuition upfront but meet the bill for their education through the progressive tax system once their income reaches a certain threshold. And the U.S. offers students the option of repaying their student loans through an income-contingent program and the income-based repayment program.

The details of comprehensive reform along these lines have been worked out by Kevin Carey, policy director at Education Sector, a Washington, D.C., think tank; David Moss, professor at Harvard Business School; Thomas Kane, economist at the Harvard Graduate School of Education and other scholars.

Such a comprehensive overhaul of how we pay for college would have advantages. It would encourage more students to attend college, and students might feel freer to explore the job market without the pressure of hefty monthly student loan payments hanging over their finances. It would also limit the downside risk of running into bad luck, such as matriculating during a major recession.

At any rate, a college education is still well worth the investment. The flaw, it seems to me, is in how we pay for it. But until there is comprehensive reform, college students need to guard against borrowing too much. The risk of big earnings swings for the average college graduate isn't going to go away — not even when the economy eventually comes roaring back. Caveat emptor.

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