When it comes to paying for school, it can be tough to decide whether it is better to pay for college expenses out of a savings account or to borrow additional student loans.
Some people are very reasonably debt-averse, but exhausting a savings account comes with significant risks as well.
There are several considerations that students should examine before making this particular decision.
The Value in Having an Emergency Fund
Not having an emergency reserve is arguably the most substantial danger of using cash from a savings account to pay for school.
Common financial emergencies include medical bills, losing a job, and essential repairs to a home or car.
For the average student, having a robust savings account might not be as important as it would be for a single parent with two kids. Still, having money set aside just in case is important for anyone.
Once students finish school, it might be hard to find a job. Similarly, entry-level salaries might be lower than expected. Having some money set aside in savings could make the transition to the workforce a little less stressful.
Regardless of the situation, having some money set aside for an emergency is a good idea. Many sound say that it is a necessity. The real question is how much to save. (This site has previously taken a deep dive into calculating an ideal emergency fund balance.)
Students that have a large savings from years of working may be fairly comfortable using funds from their savings account. Those with smaller savings account may want to leave the money in reserve when planning to pay for college.
Distance to Graduation/Future Borrowing Needs
A student’s proximity to graduation may also influence whether or not they want to dip into their savings to pay for school.
A college freshman likely has multiple years of school ahead of them. The ability to borrow student loans in the future is never a certainty. As a result, it might make sense to keep some tuition money set aside to handle tuition increases or an issue qualifying for a student loan at a later date.
On the other end of the spectrum, a student in their last semester of graduate school may already have a job lined up. Someone about to start generating an income might want to avoid any further student debt. In this case, digging into savings to avoid additional loans would make sense.
Interest Rates Matter
Most savings accounts only offer a nominal interest rate on the money set aside. Savers today are lucky to earn 1% on their savings. The big interest rate question for students is how much they will have to pay on a student loan.
Student loan interest rates can vary considerably from one lender to the next.
A student loan at 3 or 4% could be considered a very good deal, while a double-digit interest rate on a student loan would be a terrible option.
Tapping a savings account doesn’t seem as essential if the student loan alternative is a low-interest loan. However, dipping into cash reserves might make a lot more sense if the only student loan option is a ridiculous 12% loan. Tools like Credible can help borrowers find a more reasonably priced loan.
Federal vs. Private Loan Options
Federal loans are a better option for almost all students.
Even if the loan has higher interest rates, a federal loan is normally preferred because of the robust borrower protections like repayment plans based upon income and student loan forgiveness programs. These federal perks can make a huge difference for borrowers caught in a difficult financial situation.
A student debating between using cash reserves or a student loan should carefully consider the loan available. Students who have federal loans available should feel more comfortable borrowing instead of dipping into a limited savings account.
Existing Student Debt
A huge consideration in the use student loans vs. pull from savings debate is the existing debt of the borrower.
Suppose a student is weighing a 6% student loan against tapping into their savings. If this student already has some student debt at 9%, the best option might be to borrow the new student loan at 6% and then use the money from savings to pay down the high-interest loan. Going this route essentially converts student debt from a 9% interest rate to a 6% interest rate.
Likewise, the same approach can be used to convert riskier private debate into federal student loans.
529 Plan Options
Some lucky students have access to funds dedicated to college expenses.
These 529 plans have special tax advantages, but the funds need to be used towards higher education expenses.
Students will want to use up their 529 funding before dipping into a traditional savings account.
Looking at the Big Picture
As with any student finance question, the long-term consequences of the decision should be carefully considered.
Students should weigh the impacts of their choice, not just for the next semester, but for years to come.