Here's how much you can borrow -- for your or your child -- without putting undue financial pressure on your business.
As a business owner, you may face the dual challenge of managing finances for both your family and your business. Often, they overlap. If you take on too much personal debt, it can limit your ability to get a term loan or line credit for your. As your personal debts grow, your business lending will likely be restricted.
Which means that one area of family finance has the potential to become particularly sticky: how to cover the cost of college for your kids, and in particular, how much student loan debt either you or your kids should incur.
If you frame the problem in business terms, it’s actually pretty easy to figure out. Let’s say you want to borrow money for your business. Your lender is going to review your financials, and is only going to lend you money in some proportion to the amount of income your business produces. So if you have $200,000 of income from your business, you aren’t likely to get a $5 million loan. The loan has to bear some fundamental relationship to the income-producing capacity of the business, or else you can’t pay it back.
Now, translate that concept to a college loan. The loan amount has to bear some fundamental relationship to the income-producing capacity of the career your child is pursuing. For instance, if your child wants to be a teacher, that profession has certain income parameters and limits. If your child wants to be a lawyer, that has different parameters. So you and your children shouldn’t blindly borrow as much as you can. You should only borrow an amount that can be supported by the income your children are likely to produce in the career path they’re choosing.
Here’s a basic financial ratio that may help you with the borrowing question: Don’t borrow more than 75 percent of what you think your child’s average annual earnings will be during his or her first 10 years on the job. For instance, let’s assume your child wants to be an accountant, and you expect total pay for that job over 10 years will be $600,000, or $60,000 a year. Well, don’t borrow more than 75 percent of $60,000, or $45,000. Of course, less is always better, but this ratio gives you some understanding of the upper limit.
If you have a $45,000 loan, at say 6.5 percent interest, to repay that over 10 years, it would cost about $6,000 a year in principal and interest, or about 10 percent of your child’s average yearly earnings. If you keep your debt load in that range, it’s manageable, and you’d be fully paid off in 10 years. If you go over that limit, your child (and perhaps you) probably will have trouble affording the repayments.
Remember, not only do you want to apply basic business principles to the college loan, but if you take on some or all of the debt for your kids, you need to be sure the debt doesn’t negatively impact your ability to finance your business. If it does, then both you and your kids could have a problem.
Now, of course, both parents and kids may say, “I have no idea how much my kid will earn or what career they might pursue.” Well, if that were a business, how would you approach it? You’d say, “If you have no idea how much money your business will earn, then you shouldn’t be borrowing much money.” And that’s the point. You have to have an idea, and you need to be very serious about it.
If your child is not sure, then you better borrow only a small amount. You can also do a two-tiered approach: Your child could attend a community college for a few years, then transfer to a four-year institution once they have a more clear career direction. That will keep the costs down and make the whole thing more manageable.
Do your best to research salary parameters for your child’s career path. If they have no career path, then I advise using the average earnings for college graduates. Then think about limiting the debt to 75 percent of their average annual earnings over their first 10 years. At least that’s a workable solution, and your kids (and you) won’t be saddled with decades of student loan repayments.
CHARLES FARRELL is a principal with Denver-based Northstar Investment Advisors and the author of the book Your Money Ratios: 8 Simple Tools for Financial Security. The Wall Street Journal called it “one of the best financial books to cross our desks.”