As students make final college commitments and submit deposits, parents get more nervous about four or more years of expenses. Is tapping into a mortgage a smart move to make payment towards college?
This question was posed to USA Today’s resident Money Watch reporter Christine Dugas, here are some quotes from Christine, with some additional notes from me.
A reader submits the following scenario and question to Christine.
- “Q: My wife and I have no debt. Our home, cars and credit cards are paid off. We make the maximum contributions into our 401(k) plans, although we don’t take advantage of catch-up contributions. But because our kids will be going to college in four years, should we take out a home mortgage now to lock in a low rate and deduct the interest payment? This way we will have some money to pay for college without borrowing from our 401(k) plans.”
1. Do not Tap the 401k or other retirement savings to pay for college: This family already gets it, but many others have been using money normally reserved for long term savings to pay for current college expenses. As I mentioned in a prior article, there has been a spike in early withdrawals creating unnecessary financial liabilities. Rule of thumb: You CAN borrow for college with student loans but you CAN’T borrow for retirement.
2. Risks and benefits of borrowing from home equity: This family has their home fully paid for. Before pulling money from the equity they should know the tax benefit may not outweigh the risks, as Christine explains:
- “I am not sure taking out a home loan to pay for your kids college education is the best decision, either. You would be putting your home at risk, which isn’t a good idea. And never let the tax benefits influence your financial decision. You can only deduct the interest on your mortgage if you are itemizing your deductions, and even then you would only benefit from the amount of deductions that are greater than the standard deduction ($11,900 for 2013). This means if you take out a mortgage and then have $13,000 of itemized deductions, you really only benefit from a $1,100 deduction. Multiply this deduction by your tax rate to get the actual tax benefit, and you will find that it really isn’t all that much.”
3. If you borrow from the home, use the home equity loan: “The interest is still deductible and the upfront costs are typically lower. However, the interest rate will probably be higher so you will need to ask your mortgage lender about your options.”
4. If you own “investment property” borrow from there first: The FAFSA requires disclosure of family income and assets. To clarify, a primary family residence is not considered an investment property. Investment property would be separate from the primary domicile, so a summer house or a condo would count if a primary home is already owned. Financial aid calculations will consider the value of the investment property minus any outstanding debt on the investment property. Take money from the equity in the investment property to reduce the value on the FAFSA, and this may be favorable to financial aid eligibility. However, if current income and other assets are already of high value, this may not make a difference. (Also, consider a re-evaluation of your real estate investments to correctly file your FAFSA)
5. Compare to private loan and plus loan options: The Parent Plus loan offers the predictability of a fixed interest rate at the expense of 7.9% and 4% in origination/guarantee fees taken out of the disbursed loan amount. They are approved in the parent name only as long as there are no 90+ day delinquencies on the parent credit report. Regardless of how high or low the parent’s credit score is, everyone gets the same 7.9% fixed interest rate. Private loans may offer fixed rates, but variable rate private loans are most commonly issued. The variable rate private loan can sport low rates in the 3% range for qualified applicants, but also have the ability to deny loans if minimum credit requirements are not met. The private loan can be issued in the student’s name, and have a parent as cosigner.
6. Financial flexibility acknowledging risk: Before taking any loan, think forward into the necessary debt elimination strategy to pay it back, and options to shift liabilities if necessary. As previously mentioned, borrowing from the home presents it’s own risks given the real estate values, and the parent’s ability to repay. Borrowing in the Parent Plus loan locks in a high guaranteed rate with no option to cut the interest rate in the future. (Some parents later use home equity at a low rate to pay back their 7.9% Parent Plus loan!) Private loans can offer a low rate, but are subject to rate variability in LIBOR or Prime rate indexes. However, of all these options, the private loan uses the student as the primary borrower, and the parent as a cosigner. The parent should look into cosigner release options that may be available on the private loan or private loan consolidation to have this debt safely removed from their credit at a future date. If no cosigner release options are available, the private loan stays on parent credit until otherwise repaid. Additionally, because the private loan is in the student’s name, they can build a positive credit history as soon as they begin repayment, preferably while they are in school to reduce the cost of interest as well. Also, student loans are not eligible for discharge in the event of bankruptcy.
Conclusion: Borrowing from home equity may be a sensible choice, but student loan options may provide better features and flexibility to meet college financing needs.