Return on investment (ROI) is a key principal when understanding the performance of assets such as real estate or stocks. It is a helpful benchmark for knowing whether money is being made or lost, and whether something is actually an investment. In the world of higher education, ROI can be leveraged to make sense of the long-term financial impact a degree will have. Ultimately, it should be used to choose a profitable major and caution against spending too much on an education.
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What is ROI?:
Theory
Rules of thumb
Goldilocks Rule
Real Estate Example
Application to Education:
Information to gather
ROI Calculator
Other factors
Summary
Next Steps
What is Return on investment?
Theory
Return on investment, or ROI, is a quick and simple estimate used to understand the profitability of a transaction, the most common being stock trading and the purchase of real estate assets.
ROI is a percentage, with the typical returns of assets such as stocks over the LONG TERM (10+ years) being around 10%. In the short term, it is much more difficult to get a consistent return close to that number. Many smart people lose huge amounts of money in the stock market in the short term.
Rules of Thumb
Follow these rules of thumb to quickly evaluate how lucrative an opportunity is:
- Increased risk leads to the potential for higher return
There is a reason the interest rates on safe assets such as a savings account are so low. With little risk, there is also little return. Assets such as stocks, which are ownership stakes in a company, COULD be worth nothing at any time if the company goes bankrupt. Because of that much larger risk, stocks typically return more than that of a savings account. There is a limit to this, as sometimes the risk is too high to justify the potential reward.
- The cheaper something is, the higher the ROI for the same growth
The less you pay for an asset, the more the return will be with all other considerations being equal. In terms of paying for higher education, this is the MOST important aspect of ROI.
- ROI does not take TIME into account
One of the major drawbacks of return on investment is that there is NO difference between the ROI of 10% over a year or the ROI of 10% over ten years. We will handle this drawback by annualizing the return based on estimated time to finish the degree.
- Financing can greatly increase ROI
Paying for an asset with someone else’s money is a quick way to dramatically increase the ROI. However, this increases the risk and always comes with a cost. In the case of higher education, think about the hit to your monthly cash flow once in the workforce that a student can incur. Use this to your advantage, but only when necessary.
Goldilocks Rule
A quick side note on risk: the key is to tread the optimum balance between risk and reward. In investing this is known as the EFFICIENT FRONTIER. A less fancy way to think about it is like Goldilocks considering what porridge (yuck) to eat. We don’t want too much risk with too much return or too little risk with barely any return. Get that perfect bowl of porridge! Fortunately, graduate degrees provide a unique return, improving job prospects while still following the Goldilocks rule.
Real Estate Example
Take a moment and imagine yourself as a real estate mogul (I know who you just thought of) mulling whether to buy a house to flip. Flipping a house involves purchasing the home, significantly improving it, and then reselling it at a much higher value. Cha-ching!
Price of house: $50,000
Closing costs: $5,000
Cost of Renovation: $20,000
Finale resale value: $90,000
Time from purchase to resale: 1 year
Scenario 1: Pay with cash
The lowest risk option would be to purchase the entire house and pay for the renovations with cash. However, the ROI will be lower to compensate for the low risk. Don’t forget about our dear friend Goldilocks. Anyway: let’s run some numbers assuming the home sells for the after-repair value (ARV):
Up-front cost: $75,000
After-repair value: $90,000
Profit: $15,000
Final ROI: 16.7%
Pretty good! That’s leaving the deal with a $15,000 dollar profit and a hard to beat ROI even in a bull market. Another advantage of the cash deal is the ability to hold the home if the ARV is less than expected without the need to pay off lenders. HOWEVER, many people do not have $75,000 just laying around waiting to be used. Let’s see what happens if financing is used.
Scenario 2: Full Finance
We’ll keep this as simple as possible and say that the purchase, closing costs, and renovations are all covered by a line-of-credit through a local bank charging 8.0% interest that compounds monthly. Leverage to the full baby:
Up-front cost: $0 ~ nada enchilada
After-repair value: $90,000
Interest on the $75,000: $7,470 ~ ONLY COST
Final profit: $7,530
Final ROI: 50.2%
NOTICE THIS: less profit because the lender has to be paid back half of the profit in interest BUT a much higher return on investment. If we jump back to our porridge stealing home invader, there is the risk of not being able to pay back the lender in the scenario the home does not rise above the $82,470 (principal + interest) ARV.
Neither scenario 1 or scenario 2 is better or worse than the other, it simply depends on your own personal situation. As is the case with paying for higher education.
Application to Education
Information to Gather
1. What is the cost of attendance?
As mentioned previously (and discussed in the Grad or No Grad? article), three options exist for financing graduate school:
- Self-funded
- Paid for by scholarship or grant
- Paid for by employer
As highlighted by the real estate example, each of these will lead to a much different return on investment. HOWEVER, keep in mind that a higher return on investment may come with a higher risk, and the two factors MUST be weighted appropriately.
If you are self-funding the degree either fully or partially then the first step is to get a good estimate on the TOTAL out-of-pocket cost. This will need to be paid for with cash or by taking out student loans.
A rough number to use for tuition is $40,000. Keep this number (or the one you found from a prospective school’s site) as it will be used to calculate ROI (rate-of-return) later on.
2. What would my earnings increase be?
A graduate degree will increase your earnings potential. A rough number to use for a Master’s degree is $10,000. This varies widely, so use this SITE by payscale.com as a reference. Do so by:
- Finding your profession
- Make a note of your current salary or the salary with only a bachelor’s degree
- Make a note of the salary with the advanced degree you would pursue
Once you have your current salary and potential salary, there is only one last number to collect.
- Time to graduate?
This is the last number needed before the calculator can be used accurately. The calculator will provide an ANNUALIZED return on investment, meaning of the total ROI is 30% total over three years, the annualized ROI will be 10%.
The time needed is highly dependent on your own situation. Find how many total credits are needed to graduate and then decide how many you can realistically take each year. A good rule of thumb is 3 years for a graduate degree and 4 years for an undergraduate degree.
ROI Calculator
Here we go, time for the calculator. Enter your numbers here:
Other Factors
ROI is a great way to see the value in pursuing a degree, but it is not a catch-all for the entire picture financially. Also consider these other factors for whether it makes sense for your wallet.
- Opportunity cost
Think about what you would be giving up if you pursue a graduate degree. Would it keep you from achieving business idea or putting in overtime at your current job? Maybe, but I argue good time management can mean little will be sacrificed other than Netflix, and other ventures can be pursued in tandem with the degree.
- Have all financing options been looked into?
Have you applied for all relevant scholarships and looked into grants? There are many out there for people who qualify, and it is at least worth applying. If you are a working professional, have you fully looked into whether your employer will pay for the degree? Talk to your manager, and maybe they won’t pay for all of it but for some of it. The less you pay, the better the return on investment.
Summary
Return on investment is a useful metric for understanding whether your plan for financing higher education makes sense or not. Use it to better your plan.
If you are a working professional, make all efforts to either secure employer reimbursem*nt or save up the cash yourself. The minimum loans added for a graduate degree the better. Leverage may help return on investment but there are other factors to consider.
If you are a high school student or current undergraduate, make all efforts to secure scholarships and grants while you have the chance. Otherwise, a job during school will go a long way towards helping. Save as much as possible from any summer jobs or internships. Getting through with only the minimum federal student loans or none at all will put you way ahead of the curve!
Either way, make sure that education will help you gain an increase in salary and that the return on investment is worth the cost involved.
Next Steps
The next-steps on the path:
- Study What?
