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College Prepaid Tuition Plans: Not Nearly As Good As Advertised

As college tuition rates continue to rise at a rate far above the current rate of inflation, many parents of prospective students are facing increased difficulty in figuring out a way to pay for it. Sure, you can always take out a big fat loan but graduating from college saddled with tens of thousands of dollars in debt is not quite the ideal solution either.

As another tool to help families save, many states began offering prepaid college tuition plans. The premise was very simple. If you want to avoid getting stung by the continuing inflation of tuition costs, you can buy prepaid tuition credits that essentially allow you to lock in future tuition at today's prices. Sounds like a pretty good deal, right? On the surface, yes. But, like an onion, start peeling back the layers and it starts to stink.

The way that the typical prepaid tuition plan works is pretty straightforward. You pay a set amount today - potentially years in advance of when you'll actually need it - in exchange for the guarantee that your tuition will be covered at a later date. One of the big selling points of the prepaid plan is that it takes a lot of the guesswork out of saving for college. You don't need to necessarily worry about if inflation will cause tuition costs to spiral out of control because you're able to lock in those costs today.

But what you get with the prepaid plan isn't always what is advertised.

State governments like to publicize the fact that you can lock in tuition at today's rates with a prepaid tuition plan. But the "rate" that they're referring to is NOT the current going rate of tuition at a typical four-year university. It's the rate that the plan will charge to lock in future tuition credit. And those two rates can be very different from one other.

Take the Florida Prepaid Plan for example. In the past, Florida charged a tuition rate that was similar to that of a current four-year public university. That was back when tuition was rising at a more reasonable rate and the state felt that it could earn a return on the plan's assets that could keep up. Now that tuition is rising at rates far above the rate of inflation, the state allows the plan to charge what it calls a "tuition differential". In reality, that's just a fancy way of saying that now they can charge you more than the current tuition rate.

And Florida isn't the only state doing this. Programs in Michigan, Illinois and Nevada also allow savers to be charged these premium prices. In some cases, the rate these programs are charging to lock in future tuition is as much as double that of current prices. You may think that you're avoiding inflation by investing in one of these programs but in many cases you're just locking in a very inflated rate. In some cases, the rate is so inflated that it takes much of the appeal of the program away.

Despite the potentially bloated costs of participating in prepaid tuition programs, many investors find that the peace of mind of knowing that your child's future tuition is guaranteed still makes the programs worthwhile. Unfortunately for them, the lackluster economy and rising government deficits have put many of those guarantees in jeopardy.

A number of states have decided to shut down their prepaid tuition programs altogether citing spiraling costs and the inability to keep these programs fully funded. Of the programs that have survived, some no longer offer guarantees.

The Florida plan stipulates, according to its website, that it is "financially guaranteed by the State of Florida". Similarly, plans in Washington and Mississippi continue to be backed by the "full faith and credit of the state".

Programs in Michigan, Illinois and Pennsylvania though are only backed by the plan's assets. That means if the assets within the plan can't keep up with the promises made by the plan, the guarantee that your future tuition will be covered may go away.

For example, it could mean that the plan will only guarantee 80% of tuition. Alabama's plan already had to make such concessions earlier this year. The Kentucky plan is becoming significantly underfunded meaning changes could be in the offing there too. The financial viability of many of these programs is in question and that could end up putting your investment at risk.

You can start to see why some prepaid tuition plans are not fit for your portfolio. These plans were created to help lock in today's tuition costs for future use but if some of the states are charging rates that essentially bake in the cost of inflation anyway then where's the real value? If you invest your money in a prepaid plan under the notion that you're guaranteeing future tuition credits and that plan ends up dropping the guarantee or shuttering its doors altogether then how is that helping you get ahead?

529 plans and Coverdell savings accounts seem to be more reliable alternatives. If you do choose to invest in a prepaid tuition plan, look at the plan's financial status and what types of guarantees they're able to maintain. There are still some good deals out there. But if you end up investing in a plan that is unable to deliver what was promised to you it'll end up doing more harm than good.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.