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Affluent Investor | June 23, 2017

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Do the Math: How Opportunity Costs Multiply Tuition

Photo by Getty Images

Photo by Getty Images

Continued from Part 3.

Derek* attended a Christian liberal arts college. He majored in Youth Ministry and graduated with roughly $80,000 in debt. After graduation, he was hired to work about three hours a week as one of two youth group leaders at his church, where I met him. The other group leader had a day job as a salesman for a small business, for which he had no schooling whatsoever.

Crippled by his debt, Derek was forced to move back in with his parents after he graduated. He supplemented his tiny youth leader income by taking a job at a mental health facility.

Derek went on like this for years, using the latter job to support the job he wanted, and went to school for. Eventually, he decided to attend nursing school because a nursing degree would allow him to be promoted at the mental health facility. “Going to college helped me with youth ministry, but I did not need to go to college to do this,” he said. “If I could go back, I would’ve gone to nursing school instead.”

Derek deserves credit for fighting through his loss aversion, and for speaking so frankly about it; it’s a valuable lesson. But it’s even more valuable to learn these lessons from others and avoid these situations altogether.

*Name changed to protect privacy.

Lost Earnings

We’ve spent a lot of time talking about the obvious costs of college: tuition, housing, food, etc. We’ve also looked at a few less obvious costs, like interest on student loans. But there are indirect costs, as well: opportunity costs.

“Opportunity cost” is an economic phrase. Simply put, it’s the cost you incur by doing one thing rather than another. Because our time and money are finite, everything we buy or do prevents us from buying or doing something else. If you take a year off to backpack across Europe, you’re not just losing the money you spend on food or travel; you’re also losing the money you would have earned if you’d worked instead. The benefit of a decision is not just the result, but the result relative to what else you could have done. Needless to say, this concept has huge implications for higher education.

The average full-time college student misses out on a little over $9,000 in earnings for each year they spend in school. That rises to $15,500 for the 25% of students who don’t work at all. And that qualifier—“for each year”—matters more than you might think, as nearly 60% of students take six years or more to graduate.  This means that the diligent students who both work and graduate in four years still miss out on over $36,000, and the ones that take their time and don’t work at all can forego over $93,000 in income. And when you combine this with student loan debt, even those who manage to find a substantially better job will be playing “catch up” for a while.

How long, exactly? Laurence Kotlikoff, professor of economics at Boston University, decided to find out. In his article, Study This to See Whether Harvard Pays Off, Professor Kotlikoff created four fictional 18-year-olds: Joe, Sue, Matt, and Jill, and had each of them make difference choices about education and profession:

  • Joe decides to become a plumber, and doesn’t attend college.
  • Sue gets a bachelor’s in education.
  • Matt also gets his bachelor’s in education, but spends an additional 2 years to get his masters.
  • Jill decides to become a doctor, attends a private college for 4 years, then a medical school for 4 years, works as an intern for 2 years, works in a low-paying residency position for 1 year, and finally gets a job as a general practitioner.

Professor Kotlikoff placed his four creations in Ohio and simulated their professional lives using earnings data based on their age, state, and occupation to determine their likely salary before taxes, and in today’s dollars. He assumes they retire at 62 and die at 100. Here’s how they look at age 50, the peak earning year for each:

  • Joe the plumber makes $71,685.
  • Sue the teacher makes $89,584.
  • Matt, the teacher with the master’s degree, makes $103,250.
  • Jill the doctor makes $185,895.

Professor Kotlikoff then used financial planning software to calculate the sustainable spending for each of them, taking into account the host of their education, lost earnings, taxes, Social Security benefits, and Medicare Part B premiums. The idea was to get past their advertised income (which doesn’t take any of these things into account) and compare their actual spending power. I’ll let him summarize the results:

“Jill, the doctor, has the highest living standard. She gets to spend $33,666 year in and year out from age 19 through 100. This is after paying all her taxes and Medicare Part B premiums. Age 100 is the maximum age to which the kids might live and, thus, must plan.

Come again? Only $33,666? That’s a far cry from Jill’s peak earnings of $185,895. Yes, but remember, Jill has only about 31 years of significant earnings to cover some 81 years of living. And when Jill works, she gets nailed by the taxman. At age 50, for example, Jill pays 36 percent of her earnings in federal and state income taxes and payroll taxes.

Finally, Jill has a bucket load of student loans to repay at an assumed 5 percent real interest rate, which exceeds the assumed 3 percent real return she can safely earn on her savings.

To add insult to Jill’s injury, Joe the plumber’s sustainable spending is almost as high — $33,243. All those grueling years of study, exams, late-night emergency calls, and Jill gets to spend a measly $423 more per year than a plumber.

What about Sue, the teacher? Sue has less spending power — $27,608 — than Joe.

And Matt, with his masters? His spending power is even lower than Sue’s, at $26,503. Too bad he didn’t run the numbers before sending in his graduate-school application.“

This neatly illustrates the problem with most college wage comparisons: they arrive at their results by simply ignoring this complexity. Most don’t go beyond subtracting tuition costs. If you’re really lucky, they’ll be thoughtful enough to account for loan interest. But that appears to be the upper bounds of due diligence on the topic.

You wouldn’t buy a house without considering the difference in property taxes, the costs of moving, or the relative benefit over your current living situation. But that’s exactly what these comparisons are asking prospective students to do: to ignore the things that don’t show up in the purchase price, even if they do show up on the bottom line.

And this is assuming that college graduates find jobs commensurate with their education level, and do so in a reasonably timely fashion. But that isn’t always the case; in the next installment, we’ll look at “underemployment,” and what kind of jobs graduates actually end up taking.

 

Article originally published on Forbes.com.

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