If you’re a parent and you are concerned about how you are going to fund your child’s college tuition, you are not alone.
One recent Princeton Review Survey showed that over the last 13 years the biggest concern for college applicants and parents has totally shifted.
In 2006 the concern was not getting into the top choice school. Then it was not being able to afford the top choice school. Now it’s the level of debt required just to go to school.
It’s a legitimate concern since the college board recently reported that a moderate budget for an in-state school is currently $25,290. It’s much higher for private schools, and if you have young kids, you can expect this amount to be exponentially higher by the time they are ready to leave the nest.
Once my wife and I found out we were pregnant with our son Rex just over two years ago, my subconscious automatically started thinking about this massive looming future cost.
Because I fully believe a good piece of real estate is the best investment a person can own, I turned to the power of rental property to solve the problem.
After running the numbers, I was pretty blown away to see how powerful this can be for anyone whose kids are still fairly young.
The traditional way to save for a child’s college is to start a 529 savings plan that works similar to a Roth retirement savings plan. You save some portion of your after tax earnings each month in an investment account and it grows over time and can be withdrawn tax free for any school related expense.
I love any investment that keeps the government from taking my hard earned dollars. However, I hated the idea of adding another expense to our monthly budget for the next 18 years in the form of a contribution to this account.
Instead, I realized it is possible to own one investment property that not only costs nothing each month, but actually creates extra income, in addition to saving all the money our son will need to pay for college.
It’s a byproduct of the 5 major benefits of real estate:
- Leverage – The ability to buy an expensive investment with a small amount of money.
- Principal Paydown – The income from the investment (ie the monthly rent check) pays off the loan used to buy the property.
- Appreciation – Based on historic trends, real estates increases in value 3.5% nationally each year on average.
- Cash Flow – Extra cash kicked off by the investment after all the expenses are paid.
- Depreciation and Tax Reduction – Over 27.5 years, the IRS allows the owner to write off equal amounts of the value of the home every single year on their taxes, as if the property is decreasing in value by that much (even though it is probably increasing). The owner can also write off any interest paid toward the mortgage payments that year.
Here is what we did step by step:
1. The House
We found and purchased a 4 bedroom ranch that needed some TLC in Country Club Hills, which is a working class suburb of Chicago.
The house was listed for $80,000 which was a great deal based on other 4 bedrooms in the area. However, it was a short sale (the seller owed more than the sale price) so the bank had to agree to the purchase price, which luckily they signed off on.
Ironically we closed on the house on June 28th and our son was born 3 days later on July 1st.
We purposefully targeted a well constructed ranch, with no basement, built in the mid 70’s, because we knew most of the work the home needed was cosmetic. Once fixed up, this type of property requires relatively little maintenance compared to much older homes in the city.
2. The Mortgage
We took out a standard conventional mortgage from our bank for $64,000 (80% of the purchase price) and paid for the remaining $16,000 out of our savings.
We decided to make the mortgage 15 years as opposed to the standard 30 years, so that it would be paid off well before Rex was leaving for school.
This raised our monthly payments a bit because of the shorter payoff period, but it also lowered the interest rate.
The interest rate on the property is 4.875% (investment property mortgages are always a little bit higher rate than personal home mortgages) making the entire principal, interest, tax, and insurance payment $998 per month.
We estimated that the house was worth conservatively about $130,000 fully rehabbed, so we invested another $20,000 to renovate it and prepare it for a tenant.
3. The Rent
Once the makeover was done, we rented the property for $1,900 per month and manage it ourselves, which requires minimal day to day work once the tenant is in place.
Of the $1,900 rental payment, we use $1,000 to pay the mortgage, put $400 in a 529 savings account for Rex, set aside $250 for inevitable maintenance and vacancy, and are left with an additional $250 of additional monthly income.
4. The Breakdown after 18 years (prepare your mind to be blown)
The house will be fully paid off through the rental income and worth approximately $165,000 in 18 years based on very conservative appreciation.
$86,400 will have been contributed to the 529 account ($400 per month x 12 months x 18 years = $86,400). If this grows at an average 8% per year compounding annually while we are investing in the account, the account will be worth $187,551 at the end of the 18 year period.
After the 15th year the house will be paid off (remember it’s a 15 year mortgage), providing an extra $495 per month to the 529 account, which is the principal and interest portion of the current $998 total mortgage payment. This equates to an additional $20,826 at 8% annual return for three years.
Another $54,000 will have been set aside and presumably spent on vacancy or maintenance costs ($250 per month x 12 months x 18 years = $54,000) in order to keep the property in decent shape while it’s being rented.
Finally an extra $54,000 free cash ($250 per month x 12 months x 18 months = $54,000) would have been added to our household income from the property.
Therefore, if we don’t count the free cash flow or the maintenance and vacancy set aside, the final amount that is available in 18 years for Rex’s college is $165,000 value of house + $208,377 value of 529 account = $373,377.
This also does not factor in the additional annual tax write off on the mortgage interest and depreciation allowed on the property.
This also assumes we sell the property in 18 years in order to tap into the proceeds for college.
However, since the 529 account will be available to cover the initial college expenses, I expect that we will most likely keep the property and use the rental income to supplement any other college expenses. Once college is no longer a need, the home becomes an asset that pays into perpetuity.
Of course these are all theoretical numbers and there are lots of scenarios that can play out between now and the time our son leaves for college. We are only a year and a half into this 18 year plan, but even if we end up somewhere in the ballpark of our projections, Rex’s college should be pretty well covered.
You can do many different versions of this. You don’t have to rehab the property. Buying something that is rent ready at market value leads to less out of pocket cost up front (for the rehab). I just like rehabbing because it builds a little more equity.
The key is finding a solid property for a great price in a high rent area (typically near a city) and managing it well. Your kids will thank you for it!