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How to Pay for College

My first child, Jonathan, was born in April, so naturally my thoughts began turning to college. After all, I'm a Fool, I understand the magic of compounding, and few people have greater potential to take advantage of that magic than my bald, drooling, college-bound son. With that in mind, I began to work through a strategy to ensure that Jonathan has the flexibility to do what he desires.

First things first
Before even thinking about college, it's important to make sure that higher-priority items are addressed. It would be sad if I were to die in a horrible lawn-bowling accident. But, since I'm the primary breadwinner, it would be particularly tragic if this resulted in financial difficulties for my family. So, based on research from Fool's Insurance Center, I purchased enough life and disability insurance to replace my income for 20 years should an unfortunate event occur. Plus, my wife and I made wills to ensure that a friend will take care of Jonathan.

The other issue that I believe comes before college planning is retirement planning. It would be difficult to tell Jonathan that we didn't have money to help him out with college. It would mean that he might have to go to a less-expensive school than he would like or take fewer courses so he could work part time. But it would be even harder to tell Jonathan, just when he's thinking about a family of his own, that we don't have money for retirement and that we're hoping that he can help pay our bills for the next 30 years. So I made sure that our retirement plans were in place before looking at the college plan.

Calculating college costs
If your retirement is secure, it makes sense to start planning for college. Unlike retirement, where poor calculations can lead to a diet of cat food and roadkill, rough calculations are sufficient, because the consequences of incorrect assumptions aren't nearly as severe. I'm not that worried if Jonathan has to work summers to pay part of college costs.

You can frequently find current estimates of the cost to go to a particular college using a search that is limited to that college's website. For instance, if you're considering Harvard, try searching on Google (Nasdaq: GOOG  ) for " costs."

Then you can go to the nifty Motley Fool College Calculator, plug in your estimated savings rates and rates of returns, and determine the amount of money you need to save. In my case, I used the assumptions that the current cost of college is $20,000, my rate of return will be 8%, inflation will be 3%, and the money is tax-sheltered. With those assumptions, I need to save about $250 a month.

How to save
There are several different account types that you can set up. Our College Savings Center provides a great discussion of the advantages and disadvantages of each type. Key considerations include tax implications, fees, and what will happen to your money if your child decides not to go to college.

A great way to set up these accounts is using the automatic investment plan sneaky savings trick. The idea is to set up automatic monthly transfers of money from your checking account into an investment account, so that you never actually see the money that you're saving for college. Aside from being convenient, this strategy reduces the temptation to skip a month or dip into your child's college fund to buy the latest Eminem CD. I'm such a fan of this simple strategy that I started automatic investments three months after Jonathan's conception (yes, my friends do mock me for this).

Evaluating investments
College is 18 years away for Jonathan, so equities make sense. When he's closer to needing the money, it will be a good idea to move to less volatile investments. So today's question is: What type of equity investment?

My initial thought was individual stocks. It would be glorious to buy the next Amazon (Nasdaq: AMZN  ) or Cisco (Nasdaq: CSCO  ) . I can imagine the conversation: "Jonathan, we've been saving money for you for college. Here's $500,000. Have fun."

The problem is that high-growth investing is about taking sensible risks to find that one stock that goes to the moon. You must be willing to strike out multiple times before finding that grand-slam stock with 1,000%-plus returns. That's great for a large portfolio. But in something small like the college fund, there isn't enough cash to diversify risk among 20 picks, so the strikeouts could be deadly. "Jonathan, we've saved for college but had some bad luck. Here's $5,000 and a bus pass."

After that, I considered more conservative stocks, reasonably priced with strong long-term competitive advantages, such as Colgate-Palmolive (NYSE: CL  ) or Coca-Cola (NYSE: KO  ) . But, upon reflection, this didn't seem like a good option either, because any single company can have bad news that devastates the stock. Diversification is a key component of a sensible investment strategy. Which, in the case of a small portfolio such as Jonathan's college portfolio, almost necessitates mutual funds.

Fun finding funds
Mutual funds come in two flavors, actively managed and index, both of which are appropriate for a college savings portfolio.

Actively managed funds attempt to outperform the market by buying stocks that the manager believes will have superior returns. They are particularly compatible with the automatic investment plans, since most funds offer monthly purchase plans.

On the other hand, index funds simply try to duplicate a stock index representing an "average" of a market or sector. Evidence suggests that index funds outperform most actively managed mutual funds.

In either case, it's worthwhile buying a relatively diversified fund, rather than a fund focusing on a narrow niche like medical implants for pets. The goal in buying funds was to obtain diversification, and this goal is not achieved in a niche fund.

Another factor to consider is fees. Many esteemed investors expect real returns to be approximately 6%-7% in the next decade, so even a 1.5% fee will cut into those returns dramatically. With any investment, it is critical to understand the fees you will pay, and this is particularly true of investments such as prepaid tuition plans. If you are unable to understand the fees associated with a mutual fund or savings plan, then that's a good reason to look elsewhere.

I'm terrible at picking mutual funds. I can't easily buy U.S. mutual funds since I'm a Canadian, and I think fees are a blight on long-term returns. Hence, I'm going with exchange-traded funds (ETFs), a type of index fund that can be purchased like a stock and generally has low fees, in some cases under 0.2%. Every year, I'll take the money accumulated in the automatic investment plan and purchase an ETF, probably starting with the iShares S&P 500 (AMEX: IVV  ) or VIPERs (AMEX: VTI  ) , which tracks the Wilshire 5000.

Then I'll relax and watch my son and his college investment portfolio grow.

Want to discover the best actively managed funds for your money? Take a free, no-obligation trial toMotley Fool Champion Fundstoday.

Or if you want to read more about saving for your children's college education, check outThe Motley Fool's Guide to Paying for School: How to Cover Education Costs from K to Robert Brokamp.

Fool contributor Richard Gibbons' parents put retirement first, but Richard is happy with this, since, on a teacher's salary, they were able to raise two children and secure a comfortable retirement. He does not own any stocks mentioned in this article, though he does own index funds. The Motley Fool has a disclosure policy.

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