College Tuition Challenges? Try a 2nd Mortgage!
Thanks to the skyrocketing cost of tuition, many Americans have taken to searching the couch cushions to find the money to afford the high cost of college. As a result, more and more consumers are turning to the homes in which these couches are placed to finance a college education.
Tapping your home equity with a second mortgage
A second mortgage is a broad term that applies to any home loan you have in addition to your main, primary mortgage. They're often called second liens because in the event of foreclosure, they only get paid off after the primary mortgage has been satisfied - they're second in line in other words.
To qualify for a second mortgage, you have to have equity in your home - that is, the percentage of your total home value that is paid off. So if your home is worth $250,000 and you still owe $150,000, you have $100,000 in home equity - or 40 percent of the home value.
When you take out a second mortgage, you'll generally want to have at least 20 percent equity remaining after taking out the loan. Some lenders will allow you to go lower than that - some will now let you go as low as 10 percent, which they wouldn't do in during the Great Recession - but going below 20 percent equity means you'll have to pay for mortgage insurance on the loan, which will boost your cost of borrowing.
Because second mortgages are, after all, mortgages, the interest paid on them is tax-deductible, assuming you itemize and meet IRS guidelines.
If you're looking to pay college costs, the types of second mortgage you'll be interested in would either be a home equity loan or a home equity line of credit (HELOC). Either can provide you with access to cash and the means for you to finance the college of your child's dreams.
Home equity loan
A home equity loan is exactly what it sounds like: a loan backed by the equity in your home. A standard home equity loan allows you to borrow the money you need as a single a lump sum, and repay it as a fixed-rate loan over a certain length of time, known as the term. These vary in length and can be as long as 30 years.
The interest rate on a home equity loan will be higher than what you'd pay for a regular mortgage, because it's a second lien, as described above. That makes it somewhat riskier for the lender. However, the closing costs are considerably less than what you'd pay on a cash-out refinance (see below), which is yet another way of borrowing against your home equity.
Home equity loans usually have certain minimums, meaning you have to borrow at least that much for the lender to approve it. This minimum often ranges from $10,000-$20,000. If you don't need quite that much, a HELOC (see below) may be a better option.
Home equity line of credit (HELOC)
A HELOC is a home equity loan with a twist: rather than giving you a single lump sum of cash at closing, you're set up with a line of credit you can draw on as needed. So if you get a $40,000 line of credit, you can borrow various amounts as you wish, as long as the total doesn't exceed $40,000, or you can even borrow the whole $40,000 all at once.
HELOCs offer a number of attractive features that make them suited for a purpose such as funding a college education. First, since you can draw on them as needed, you can borrow just the amount you need when you need it - such as at the beginning of every term or semester to help pay for tuition or books.
Since you're only drawing money as needed, you're only paying interest on what you've borrowed so far - as opposed to a standard home equity loan, where you start paying interest on the whole amount immediately.
A HELOC can also provide financial flexibility, as you can repay part or all of the principle when you have the funds to do so, then draw on it again when you need cash. This makes it a useful cash-flow management tool for parents with irregular incomes.
HELOCs have a draw period, during which you can borrow against your line of credit, following by a repayment period, when you must pay off the principle as a regularly amortizing loan. They're usually set up as an adjustable-rate loan during the draw, with a rate cap to limit how high the rate can go, and a fixed-rate loan during the payback.
Closing costs on HELOCs tend to be lower than on standard home equity loans, even nonexistent. However, most will charge an annual fee during the draw period.
About cash-out refinancing
As mentioned above, another way of borrowing against your home equity is a cash-out refinance. The interest rates are lower than on a home equity loan, but the closing costs are considerably higher because the transaction involves a much larger total sum of money. For this reason, a cash-out refinance works best if you want to borrow a large sum of money, or if refinancing will provide some other benefit as well, such as lowering your interest rate or converting an adjustable-rate mortgage to a fixed rate.
Stay within your budget
As a parent, you need to set limits on how much you borrow. As tempting as it may be to send your kids to the finest academic institutions, you need to stay in fiscal reality. The rule of thumb is to avoid spending more than 35 percent of your take-home pay on debt. This way, you'll always have a little wiggle room for any unexpected expenses looming down the road.
The ultimate guideline for how much you borrow is your heart. If you feel that borrowing money to pay for a better education is extremely important, it's your choice to exceed the recommended debt limits.
In any case, a second mortgage may be the most economical way to help you afford a monster college expense.
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