Calculating Return on College Investment

So what exactly is this buzzword, Return on Investment (ROI)?  Put simply, it is a measure of what you get for what you put in.

Suppose you invest $1,000 in a bank that promises you $1,020 at the end of one year and an alarm clock, simply for opening an account with the bank.  You check online and see that the value of the clock is $15.  Your return would then be $20 + $15 = $35 on a $1,000 investment, a 3.50% return.

It is clear that there are essentially two quantities which determine your ROI.  What you put in or the cost.  And then, what you get for what you put in, or the return.  Dividing the return by the cost gives you the rate of return.

Common sense tells us that to increase the ROI, one must somehow lower the cost, or increase the return, or do both.

Returning to the bank example, if a second bank, say Bank B, offered you the same deal - $20 at the end of the year and an alarm clock - for an investment of only $750, your gut would tell you to choose this bank, other things being equal.  And you would be mathematically right - because this bank’s return would be $35 on a $750 investment, a 4.66% ROI.

If another bank, say Bank C, offered you a deal - $30 plus an alarm clock - for a $1,000 investment, the return compared to the first bank would be $30+15 = $45, or a 4.50% ROI.  But it would still be lower than that of Bank B’s.

Calculating the ROI for college follows the same method except that you have to figure in what economists call Opportunity Cost.  It is simply an estimate of how much you benefit over a particular period - say, a lifetime of work - for what you put in to attend college.

Clearly, the first and easiest step is to figure out how much it will cost to attend college.  Few people have already saved up all the money it takes to go to college, so you will probably have to estimate the total loan you will have to take, including interest.  Taking out a loan will naturally add to the cost of attendance.

Second, figure out the opportunity cost - that is, how much money you would notionally lose had you worked at a job instead of going to college.  Here, an important element is how long you will take to earn your degree.  The longer it takes, the more expensive college becomes.  After all, time is money. 

Third, calculate how much money you would make after graduation. 

Finally, using a familiar financial analysis technique called Net Present Value, you compute the total earnings after adjusting for the total cost of college attendance, the interest on the loan and opportunity costs.  Believe it or not, the entire problem can be brought down to a single number.

The cost of attendance  

The easiest thing to do is to calculate the cost.  US colleges go to great lengths at publishing what it would take to attend their institution.  While grants, scholarships and other forms of financial aid information are not specific to you until you apply, the costs are fairly generic and easily available.

At Texas A&M University (TAMU), one of the best public universities in the country, the total “Sticker Price” cost of attendance (tuition, fees, living) for a Texas resident for a year (Fall & Spring semesters) is $24,024.  If you graduate in 4 years, the cost of college will add up to $96,096. 

Sticker Price against Net Price Just like buyers of cars never really pay sticker price and are able to negotiate a lower price before driving them out of a dealer’s lot, most families rarely pay the sticker price listed on a college website.  The net price of attending college is highly tailored to an individual’s situation and considers a variety of factors unrelated to the merit of the student - such as if parents are unmarried, divorced or separated; the number of children in college; the size of the household; family income, savings and commitments, such as alimony; family debt; willingness of students to work in the summer or during term and so on.  Colleges and universities quote their net price estimates based on this information. Two students with identical academic accomplishments can therefore be offered entirely different net price estimates from the same school.  The College Board reminds us: “It is possible that your net cost will be lower at a college with a high sticker price or higher at a college with a lower sticker price. You may find that some colleges you thought were financially out of your reach may be very affordable.” Throughout this book, we use the “sticker price” to model all of our calculations recognizing that for most families, the “net price”, being lower, will likely bring these very calculations more in their favor.  To estimate net price, visit your desired school’s website and be prepared to spend 20-30 minutes to answer many questions about your situation to get the most accurate estimate.  Or you could go to the one-stop site of the College Board’s and do the same for the many participating colleges on the site.  Another net price estimator site is run by College Abacus, which claims that nearly 5,000 colleges participate.

Assume that you borrow $80,000 to attend TAMU at an interest rate of 6.80%.   That is, you are able to somehow corral $16,000 in cash from family and friends so that your loan amount is slightly lower than the actual cost of attendance.   Suppose that, on graduating after 4 years, you earn a nice job paying $41,000 a year.  Because you are a college graduate, we will assume that you will get 5% annual raises throughout your career. 

Now that you have begun earning, you will have to start paying your loan off.  Education loans don’t require any collateral - that is, they don’t require your parents or others, with income, to co-sign for you should you default.  According to federal law, education loans have to be disbursed solely on the student’s future ability to pay.  In return for this benefit, federal law is very strict about the student’s obligation to repay.  In most cases, education loans cannot be discharged even in personal bankruptcy.  

Suppose you commit to a payment of about $700 a month towards the loan.  How long do you think it will take for you to pay your loan off?  The answer:  A very long, 15 years.  And you would have paid a whopping $47,826 in interest alone - more than half of the amount you borrowed. [Model these numbers into an online loan calculator such as the one from Wells Fargo].  It is little wonder that the financial services industry is doing so well.  The total of principal and interest over the course of the loan will be a whopping $127,826.  As we said, going to college is expensive.

The opportunity cost 

This too is relatively easy to calculate.  Remember that the opportunity cost is simply the money you would have made had you worked at a job instead of going to college.  Suppose that upon graduation from high school, a friend of yours who chose not to go to college but has similar skills got a job as a telecom technician for a cable company and makes $13 an hour.  Assuming a 3% raise each year, your friend would have made $26,000; $26,780; $27,583 and $28,411 during the four years you would be at college, a sum of $108,774.  Some may question the raise assumption but experience has shown that whatever may be the individual numbers, college graduates typically do get better raises.  

It is important that the day you graduate, you would be $16,000+ $80,000 + $47,826 + $108,774 = $252,600 “in the hole”.  This amount reflects not only what you spent to graduate from TAMU in 4 years (down payment towards fees plus principal plus interest), it also represents the opportunity cost - that is, what you could have earned had you chosen to go the route of your telecom technician friend.  Technically, the $47,826 you pay in interest is over 15 years and we will model it as such shortly.

Notice how the four year graduation rate is critical.  If you took six years to graduate from TAMU, even assuming that you didn’t pay anything extra in tuition, you would have paid an extra $29,000 to live on campus - so we need to add this to the original loan amount.  Your new loan amount will now be $80,000 + $29,000 = $109,000.  Paying $832 a month, you will need 20 years to pay off your loan.   And you would have lost $29,263 +$30,141 that your friend will have earned in years 5 and 6.  The net result is that you would be $383,858 in the red at graduation.

Unfortunately, the graduation rates at US colleges are poor.  According to the US Department of Education, the average six-year graduation rate for first-time, full-time students who began seeking a bachelor's degree in 2007 is just 59%. 

Earnings Table 

The fun begins when you start earning after your 4-year graduation.  Look at the adjoining table.  At the same time your friend made $29,263, in year 5, you would start off making $41,000 a year.  Ten years after you graduate (year 15), you would be making $66,785 but your friend, only, $39,327 (Column C).

But Column D is what really matters because this is the amount left after you have paid out your education loan for the year (indicated by the red boxes).  The green box represents the last year of your college loan after which you are free from this burden.

Notice also that for the first several years after you graduate, your telecom technician friend is doing well overall although your earnings are higher.  In fact, the inflection point is in Year 15, a full 11 years after graduation.  See Column E and the adjoining graph.  At this point, your total cumulative earnings are higher than your friend’s cumulative.  From this point on, your advantage over him widens.  By Year 30, you would have earned $716,691 more than your HS friend. 

Calculating ROI 

Net Present Value (NPV) is a calculation that compares the amount invested today to the present value of the future cash receipts from the investment.  It is a simple but powerful approach to bring forward a series of cash flows each year to a single number, a value in today’s dollars, eliminating the time component forever.  NPV calculators are available online and as a function in most spreadsheets.

An important quantity needed to calculate NPV is the discount rate - the interest that takes into account not just the time value of money, but also the risk or uncertainty of future cash flows.  We are modeling two careers over a 30-year period, so it makes sense to use the 30-year US Treasury Bill rate.  Let us say this is 4%.  Notice that we will be using the same discount rate to model both careers.

 Using NPV analysis, the HS Grad income over 30 years equates to a single lump sum of $654,237 in today’s dollars.   What does this mean?  Suppose this person had a wealthy parent who gave him a gift of $654,237 for graduating from high school.  He takes this gift to a local bank and buys an annuity with an interest rate locked to the US Treasury Bill rate of 4%.  Over the next 30 years, the bank would pay him the same cash each year as his earnings working as a telecom technician.

NPV analysis is valuable because it allows us to compare two different sets of earnings over an extended period.  In this example, your NPV as a TAMU grad for the same 30-year period with the same 4% interest rate would be $894,833.  This number is 36.78% higher than the NPV of your HS friend ($654,237).

Hence, your ROI for graduating from TAMU is 36.78%.

This hypothetical situation is much better than what the Federal Reserve Bank of New York found in its study.  As mentioned in Chapter 1, the Fed said:  “An analysis of the economic returns to college since the 1970s demonstrates that the benefits of both a bachelor’s degree and an associate’s degree still tend to outweigh the costs, with both degrees earning a return of about 15 percent over the past decade.”

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