Expert: Paul Henneman - 1/8/2007

Question
My husband and I have a 9 week old baby and was given $1,000 to invest on his behalf.  What should we do...buy a CD or start a college fund now?  I didn't know if keeping a CD for now would have better yearly returns and then putting the money in a college fund later.

Answer
Thank you for your question!
Starting some sort of investment or college fund now is the best thing you can do. Any investment takes time to grow, and higher education costs can be taken care of easily with enough time. Too many wait until just before a child heads off to college, and the cost is incredibly burdensome for most.
You do essentially have two choices: create some type of investment on your own, or invest in a pre paid college program. The answer to this depends really upon what kind of person you are, and what state you live in.
First the prepaid college programs. Some states have very good ones. For example, in florida you can start a pre paid college program where you have a payment to make every month. However, this locks in current costs for college and when your child is ready to head off to school, tuition is fully paid. It is a state program, so this only applies to state Universities in your state (if your state has such a program).I would look into it.
However, it sounds like you are more interested in a single investment of the $1,000. A CD will only earn you about 5% annual return. This won't leave you with much in 16 or 17 years when your child is ready to head off to school. Keep in mind that inflation increases the cost of everything by about 2% a year on average, and college tuition has been increasing far more quickly than inflation for the past two decades. A CD will be perfectly safe, no risk, but will not result in much. Perhaps some extra money for a car, or a single semester of school.
Investing in a mutual fund, with this investment set aside for college, will earn higher returns over time. There is risk involved, the stock market can always go down and your investment drop in value. But it also always recovers given enough time. Your time horizon of a decade and a half means that if you stick out the bad times, and let it ride for the good times, you should on average produce over 10% annualized returns in a mutual fund, twice that of a CD. I realize you may not want to spend your lives researching and trying to find the best mutual fund every year. The answer to this is an index fund. These are funds that invest in the exact stocks of a major stock market index. This means that your investments will never fall short of or beat overall market performance, you will always match it. The S&P500 is perhaps the most stable and appropriate index for this type of investing. Vanguard has a very well respected Index fund that matches the S&P500, the ticker symbol is VFINX.

Let me illustrate a bit the differences. If you invest $1,000 now in a CD at 5% interest, after 17 years you will have $2,292. Not much help for college. If tuition keeps rising at current rates, a single year of public school could cost $30,000 or more.
If you invest $1,000 now in a mutual fund and average 10% per year on the return, you will have just over $5,000. Better, but still a drop in the bucket.

However, this is not the end of the story. The real secret to investing is small additional contributions every month to the investment. If you invest $1,000 now for 17 years in a mutual fund at an average return of 10%, AND add an additional $100 per month to that investment, you will have just over $58,000. Now That is a college education fund!
Even with a $50 addition to the fund each month instead of $100, you would have over $31,000.

If you wish to play with those numbers a bit, here is a link to a very simple online calculator, fill in the blanks and get the result:
http://www.ici.org/cgi-bin/calcs/SAV14.cgi/investment_company_institute


Mutual funds and other investments often have a minimum investment requirement. So this would mean that if you do decide to invest additional funds each month, you will have to set up a money market or savings account, and then every year or two when you reach the minimum, buy additional mutual fund shares.

By college fund you may be referring to the various account types that can be set up. Some of these are ok to consider, but they are often a bit complicated to understand, and it would be too lengthy to go into detail here. I do recommend that you read up on how you can structure a mutual fund or other investment into a federally recognized college fund to see if it is right for you.
My wife and I have a baby on the way, and I have just read the book "The Expectant Father" by Armin Brott and Jennifer Ash. It does have a chapter on this. Your child is already here so the rest of the book will have little interest, but this author has other books relating to the early years of being a father, and I imagine they contain information about planning for college as well. I have not read them so can only assume that "The New Father: A Dad's Guide to the First year" or the other two books by Armin Brott about the toddler years and "Father for Life" would cover education costs, perhaps in greater detail. I am sure that all are available on www.amazon.com
There are several problems with college funds as pointed out by Armin Brott and Jennifer Ash. You are investing after tax dollars, and these types of investments are often in your child's name which means that the more assets in the account the harder it will be to apply for financial aid (loans and grants).
This book does offer alot of options: Several types of bonds, prepaid tuition plans as I mention above, education IRA's (you could purchase mutual fund shares within an educational IRA for example), custodial accounts, state sponsored savings plans, and a few more. All of this is covered on pages 84 to 96 in the book I have.

Don't let this array of choices distract you. Do something now. Invest that $1,000 in an index mutual fund or at least a CD, whatever you are comfortable with. Then spend the next few months reading up on the topic, discussing it with your family, determine if you can continue to add to the fund at least a little each month, develop a budget, then act on your decisions. It is for your child, and well worth the effort to give him/her a real advantage in life come their high school graduation. Such careful planning can truly alter their life to such a positive degree.

Congratulations on your new larger family, and your foresight on his/her future! Please do not hesitate to follow up with me if I can be of any additional service,

Sincerely,
Paul Henneman
President
ValuEngine, Inc
www.ValuEngine.com