Paying for College With a Home Equity Loan
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How to handle the rising cost of a college education has become one of the biggest financial questions that parents face today.
College costs have increased to the point that the average net tuition at a public university was $4,140 in 2017-18. If you include room and board, the average cost was $14,940, and that number went up to $26,740 for nonprofit private schools.
And that’s just for one year of one child’s education. With costs that high, and with all the other financial responsibilities on your plate, it’s reasonable to ask how you could possibly afford it.
One option is to use a home equity loan to at least help pay for college expenses. It can be one of the least expensive ways to borrow for college and can therefore be a helpful piece of the puzzle in assisting your child with the cost of his or her education.
But there are some downsides to consider as well, and this article provides an overview of how home equity loans work and the pros and cons of using a home equity loan to pay for college, including comparisons of other options you have available to you.
What is a home equity loan?
In order to understand how a home equity loan works, it’s important to first understand what home equity is.
Your home equity is simply the difference between the current value of your home and the current balance on your mortgage. So if, for example, your home is currently worth $200,000 and you owe $150,000 on your mortgage, you would subtract $150,000 from $200,000 to determine that you have $50,000 in home equity.
If you have positive home equity, a home equity loan is one way you can access that money in order to use it for other financial goals. Lenders may let you borrow a significant portion of your available home equity, but it depends very much on each lender’s practices.
Going back to the example above in which you have $50,000 in home equity on a $200,000 house, LendingTree’s Home Equity Loan Calculator estimates that you could borrow up to $30,000 from that equity in the form of a home equity loan. That $30,000 would then be yours to spend as needed. Common uses include making home improvements, consolidating debt, paying for college and handling other large expenses.
Home equity loans have fixed interest rates and you will be required to make monthly payments in order to pay back the loan, just like with your mortgage. They typically have 5- to 15-year terms, and you will also have to pay closing costs such as application fees, attorney fees and the cost of an appraisal.
Like your mortgage, a home equity loan is secured by your home, meaning that the lender has the right to foreclose on your home if you are unable to make payments. This is one of the major risks you have to consider before taking out a home equity loan.
The bottom line is that a home equity loan allows you to tap into the equity you’ve built in your home to help pay for life’s other expenses. There is a cost to doing so though, so it’s worth evaluating that option compared with the other options available to you.
3 ways you can build equity in your home:
- Down payment. Your down payment is immediate home equity. The bigger your down payment, the more equity you’ll start off with.
- Mortgage payments. A portion of every mortgage payment you make goes toward paying down the principal of your mortgage, which serves to increase the equity in your home.
- Home value appreciation. If your home increases in value, your home equity will increase along with it. Of course, your home can also decrease in value and in some cases, it can decrease to the point where it’s worth less than you owe on your mortgage. In that case, you would have negative home equity. Currently, the housing market has been very good to homeowners, as a stronger economy, low housing supply and high demand have driven home values up consistently since the housing crisis of 2008.
Benefits to using a home equity loan to pay for college
If you have enough equity in your home to allow you to borrow a significant sum, it’s worth considering whether a home equity loan would be a good way to help pay for college. Here are some of the benefits to going this route.
Low interest rates
One of the main benefits of using a home equity loan to pay for college is that you can often get a better interest rate than you would from other loans, especially if you have excellent credit.
“Home equity loans are typically cheaper to obtain versus other types of loans,” said Crystal Rau, a fee-only financial planner and the founder of Beyond Balanced Financial Planning. “Also, the funds from a home equity loan are accessible and provide immediate liquidity for funding needs.”
The interest rate on a home equity loan depends on several factors, including your credit history and the size of the loan you’re looking to take out. At the time of this writing, a $100,000 home equity loan could qualify for an interest rate as low as 4%, while a $25,000 home equity loan could qualify for an interest rate as low as 5.87%.
Assuming that you take out a $100,000, 15-year home equity loan with a 4% interest rate, your monthly payment would be $739.69 and you would pay a total of $33,143.69 in interest over the life of the loan.
Here’s how that compares with other loan options.
Home equity loans vs. personal loans
Personal loans are unsecured loans, meaning that the lender cannot take your home or other property if you fail to make payments.
Personal loans often have higher interest rates than home equity loans, but lower interest rates than other alternatives like credit cards. And if you’re only looking to borrow a relatively small amount — typically $10,000 or less — a personal loan may be easier to get than a home equity loan.
Assuming that you could get a $100,000 personal loan with a 4.99% interest rate and a 5-year term, your monthly payment would be $1,886.67 and you would pay $13,199.88 in interest over the life of the loan.
That’s $19,943.81 less total interest than the home equity loan, which is a big reduction in the overall cost of the debt. But the monthly payment is $1,146.98 more than with the home equity loan, which may or may not be something that you can afford.
Home equity loans vs. federal student loans
Federal student loan interest rates are set by the U.S. Department of Education and are re-evaluated each year. For the 2017-18 school year, direct undergraduate loans come with a 4.45% interest rate, Direct graduate loans come with a 6% interest rate and direct PLUS loans — which are given out to parents and eligible graduate students — come with a 7% interest rate.
The monthly payment depends on a number of factors — such as income, family size, tax filing state and state of residence — but standard repayment over a 10-year period on a $100,000 direct PLUS parent loan would require a $1,161 monthly payment and would cost $39,330 in interest over the life of the loan.
That’s an extra $421.31 per month compared with the home equity loan, and an extra $6,186.31 in total interest.
Federal student loans, including PLUS loans, do have other advantages though, such the opportunity to use forbearance or deferment if you run into financial troubles, and the potential for your loan to be forgiven in certain circumstances.
Your child may be eligible for his or her own federal student loans as well, and those may have more favorable interest rates. You can find out what you and your child are eligible for by filling out the FAFSA application each year that your child plans to attend school.
Home equity loans vs. private student loans
Private student loans are less regulated than federal student loans, and interest rates can therefore vary widely depending on the lender, the loan amount and your credit history.
Private student loans can have fixed or adjustable interest rates, and rates in some cases can be as high as 18%. Lenders may also charge an origination fee that would add to the cost of the loan.
Assuming an interest rate of 10% with a 10-year repayment period, your monthly payment on a $100,000 private student loan would be $1,321.51 and you would pay $58,580.66 in interest over the life of the loan.
Compared with a home equity loan, that’s an extra $581.82 per month and an additional $25,436.97 in interest costs.
Other benefits of using a home equity loan to pay for college
Beyond the opportunity to secure a lower interest rate, the fixed interest rate on a home equity loans means that you know exactly what you’ll have to pay each month for the life of the loan. This makes it easier for you and your family to budget for the cost.
Home equity loans can also be extended to up to 15 years, which will increase the total interest cost compared with shorter loans, but will also reduce your monthly payment and potentially make it easier to afford.
In contrast, the standard repayment period for federal student loans is 10 years and personal loans are typically offered with 2- to 7-year terms, so in addition to the higher interest rate, you may have to make a larger monthly payment.
Risks of using a home equity loan to pay for college
While a home equity loan can be a good way to help with the cost of college, especially compared with other loan options, there are some risks to consider before you sign on the dotted line.
Your house is used as collateral
A home equity loan uses your house as collateral, which means that the lender has the right to foreclose on your home if you are unable to make payments.
If you think that you may have difficulty making consistent monthly payments, this may not be a risk worth taking.
Long application process
The process of applying for a home equity loan is similar to the process of applying for a mortgage, which means that it can take a while. You’ll have to submit a number of financial documents, have your house appraised and go through the underwriting process before you can be approved for the loan.
And if your credit isn’t good, or if your house doesn’t appraise well enough, you may not be able to take out a home equity loan on favorable terms, and in some cases, you may not be eligible for a loan at all.
No more tax deductions
With the passing of the Tax Cuts and Jobs Act, interest on your home equity loan is only deductible when the money is used to buy, build, or substantially improve your home. When it is used for other purposes, such as paying for college, the interest is not deductible.
On the other hand, you are still able to deduct interest paid on federal student loans, up to $2,500 per year subject to certain income limitations. So if the interest rate on a home equity loan and student loan are comparable, it’s possible that the student loan might be cheaper due to the tax deduction.
On top of that, Elizabeth Buffardi, a fee-only financial planner and president of Crescendo Financial Planners, points out that student loans have another big advantage.
“The real reason to use a traditional student loan instead of a home equity loan is because if something happens to your financial situation, there is usually a way to defer payments or lessen the payments until you can get back on your feet,” Buffardi said. “You cannot do that with a home equity loan.”
Cycle of debt
One downside to relying on a home equity loan is that it perpetuates a cycle of debt. You’ve worked hard to pay off your mortgage and increase your equity, and a home equity loan reverses much of that progress and reinforces the idea that more debt is the solution to every financial problem.
“Getting a home equity loan to either pay for college or to consolidate debt can be a good option for some,” Rau said. “But the cycle of debt can sometimes be more about our mindset and complacency. Instead of facing the issue head on and having the willingness to make sacrifices now, we continue to put off the inevitable so we don’t have to adjust our current lifestyle.”
You already have a home equity loan
If you’ve already tapped your home equity through a different home equity loan or home equity line of credit, you may not be able to borrow more or borrow enough to pay for the necessary college costs.
No debt forgiveness
Certain student loans offer the opportunity to have some or all of the debt forgiven, if specific conditions are met. Home equity loans do not offer the same opportunities.
However, it’s worth noting that President Trump’s 2018 budget proposal calls for the elimination the Public Service Loan Forgiveness program. And while it is certainly not guaranteed that this program will actually be eliminated, the proposal may at least cast some doubt as to whether you will be able to use these forgiveness programs down the line if needed.
Is paying for college with a home equity loan right for you?
You have a lot of options when it comes to paying for college, from paying for tuition out of your income like any other bill, to paying from savings, to taking out student loans, to attending a lower-cost university, to applying for scholarships and grants. You can mix and match those options as well, using multiple tools to help foot the bill.
A home equity loan is a good tool to have as part of that toolkit. With college costs as high as they are, using your home equity is certainly a viable option and in some cases, you may be able to get a better interest rate than you would with other types of loans.
But there are downsides as well, including the fact that you’re putting your home at risk and that all debt comes at a cost.
In the end, you’ll need to evaluate all of the options available to you in the context of your entire financial situation, as well as what you expect your child to get out of his or her college education.
If you can handle the extra monthly payment, if the cost won’t prevent you from reaching other financial goals and if the extra money will significantly improve your child’s future prospects, then a home equity loan may be a good move.