Baby Step 5: Save for College, Don't Rely on Loans

This article is an excerpt from the Shortform book guide to "The Total Money Makeover" by Dave Ramsey. Shortform has the world's best summaries and analyses of books you should be reading.

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What is baby step 5 of the Total Money Makeover program? How can you save for college?

Baby step 5 is to save for college so you can avoid student loan debt. By investing wisely and making frugal choices, you don’t have to take out student loans.

Read more about baby step 5 of the Total Money Makeover program.

Baby Step 5: Save for College

People have many erroneous beliefs about a college education, which leads them to make foolish spending decisions to ensure their children get a degree from an expensive college. Baby step 5 tackles this issue. For instance, many parents believe that:

College is a guaranteed ticket to success, therefore it’s essential their child get a degree.
An elite college provides a better education than a non-elite college. A degree from an elite college will open more doors than one from an average school.

But a college degree doesn’t guarantee a job, wealth, or success. Everyone knows a few disillusioned college graduates who can’t get a job. A degree only validates knowledge or indicates you’ve passed certain tests. Knowledge must be combined with other qualities—for instance, character, effort, persistence, creativity, and talent—to create success.

In the book Emotional Intelligence, author Daniel Goleman writes that 15% of success is attributable to education, while 85% stems from attitude, perseverance, diligence, and vision. (Shortform note: Read our summary of Emotional Intelligence here.)

Because of their unrealistic expectations for a college degree, many parents go into extreme debts or skimp on saving for their retirement or an emergency fund. In the process, they pass on harmful views of debt to their children. Baby step 5 is about being financial savvy.

A Financially Smart Approach to College

While society may overemphasize college, higher education is important and an element of success. Here are three steps for making a smart decision about college:

Research the cost of attending college at various sizes and types of schools: Remember, a degree from an elite school matters less than it used to. It’s irrational to incur $75,000 debt for a degree, when the same one from a state school reflects the same knowledge and can be funded out of pocket without going into debt.
Pay cash: Don’t take out loans for college; there are ways to fund college without loans. We’ve come to accept student loans as normal, believing that you can’t go to college without loans. Students today graduate with an average $25,000 to 27,000 in loan debt. Once you have college loans, they’re difficult to get rid of, so don’t get started with them.
Control college expenses: Too many student loans are used to pay for an expensive off-campus standard of living. It’s usually more economical to live on campus and eat in the cafeteria.

How to Save for College in Baby Step 5

While most people think college is important, most don’t save for their children’s college education. Only 14% use college savings funds (ESAs) or 529 plans, meaning that an overwhelming majority are saving little or nothing.

People often can’t save because of credit card debt, car loans, and mortgages. They don’t plan their spending with a monthly budget and lack a fund for emergencies. To be able to save for college, you need to complete the first four Total Money Makeover steps as a foundation before moving on to baby step 5. Here are ideas for how to save for college.

ESAs and 529s

The most effective vehicles for saving for college are an ESA (Educational Savings Account), which is like an IRA for education, and a state 529 plan.

College tuition increases faster than inflation, at about 8% versus 4%, so when you save for college, you need to factor in tuition inflation. There are tuition prepayment plans, but as mentioned earlier, they just break even with inflation. Savings bonds and whole life insurance for babies generate returns of only 2% to 5%. A savings account generates even less.

You can do much better with an ESA funded in a growth-stock mutual fund—like an IRA, it will grow tax-free. Here’s how it compares to a prepaid tuition plan:

If you invest $2,000 a year from your child’s birth through age 18 in a prepaid plan, you’d have $72,000 for tuition.
An ESA in mutual funds returning 12% would generate $126,000 tax-free. It would take only $166.67 a month to save $2,000 a year, and in 18 years, you’d have enough to send your child to an expensive college. But you could still probably afford a typical college if you started investing when the child turned 8.

If an ESA won’t be enough, start there and also consider a state 529 plan, which also allows you to invest money tax-free for your child’s education.

There are several types of 529 plans—stay away from the “life phase” plans (poor returns) and “fixed portfolio” plans (too restrictive). The best option is a “flexible” plan that allows you to move your investment within a family of funds to get better performance.

By saving for college, you break the cycle of debt for your children.

Other Options

If you started your Total Money Makeover later in life and therefore don’t know how to save for college with the time you have, there are other options, though you have to be creative.

First, you can save on costs if your child starts at a cheaper school, like a community college, that’s also nearby so the child can live at home. Otherwise, look for cheap housing instead of luxury student apartments.

Steps a student can take include:

Getting a job with a company that helps pay college tuition—UPS is an example
Going into the military or National Guard
Promising to work in an underserved area to get help with costs for law or medicine study
Getting scholarships: Many scholarships go unclaimed each year, yet small grants from many community organizations can add up. For example, one enterprising student obtained a database, applied for 1,000 scholarships, and received 30, which paid $38,000

Whatever you do, don’t fall for the myth that the only way to afford college is by getting loans.

Baby Step 5: Save for College, Don’t Rely on Loans