More parents are using what is probably the cheapest option when taking out a loan to pay for college — borrowing some of the equity in their home.
Parents borrowed an average of $7,406 through a home loan to help pay for college in 2016, almost double what it was in 2015, according to a a Sallie Mae study. The loans included home equity loans, a home equity line of credit called a HELOC, cash-out refinancing, and a reverse mortgage, the study found. HELOCs were the most common choice.
“People use them for a multitude of things,” with home renovations being the top reason to get a HELOC, says Tim Kinney, vice president of retail lending at TD Bank in Ramsey, N.J. The bank's own survey found that renovations top consumers’ list or reasons for choosing a HELOC. Still, the loans can be used however the borrower wants to.
Low, adjustable interest rates can make HELOCs especially attractive, though there are fixed-rate options. There are some things to be aware of when determining if one is the best choice for paying for a child’s college education. Here are some:
Do you have enough home equity?
This type of home equity loan provides a line of credit against the value of a home that can be borrowed against. At least 20 percent equity is usually required to get the best loan rates, Kinney says.
For example, if you have a $300,000 home and have paid down $150,000 of the mortgage, you may be able to borrow up to $120,000 with a HELOC. Like any line of credit, such as a credit card, you don’t have to borrow the full amount, and can borrow it as you need it.
A home equity cushion of 40-50 percent would be better, giving you some room if home prices drop. And because a HELOC is secured by the home and interest rates could rise, a HELOC may be best used as a short-term solution. If you default on the loan, you could lose your house.
“It’s always beneficial to have a cushion,” Kinney says.
Do you have more than one child going to college?
For families with more than one child in college, or one child in college and another one going in a year or so, a HELOC is a flexible way to help pay for college.
Paying back the lines of credit quickly can replenish the available credit for another child’s college expenses, Kinney says.
“For example, if a parent takes out a HELOC for their child who is a junior in college, they can pay down the line of credit with a year-end bonus or income tax credit so they can draw the line again to pay tuition for another child who is an incoming freshman,” he says.
Will it affect financial aid?
A home equity loan or HELOC could be counted toward your estimated family contribution on financial aid forms.
The good news is that if your primary home is used for a HELOC to pay for college, then the home isn’t included in the federal financial aid calculation, “so having debt against it or paying it off doesn’t really mean much for financial aid calculations,” says Scott Vance, a financial advisor at Trisuli Financial Advising in North Carolina.
But a second or investment home is included in the aid calculations, says Vance, who recommends taking a home equity loan against the second property to reduce the income in that property, and thus reduce the amount of equity in the financial aid calculation.
The homeowner could then put that equity into their primary home, which could help in the aid calculation, he says.
Ideally, this should all be done by the time the student is a freshman or in late summer of their sophomore year. FAFSA, the Free Application for Federal Student Aid, looks at a family’s finances from the fall of a student’s sophomore year to the spring of junior year, so having a plan for financial aid early is important, Vance says.
Are other loan options better?
Home loans aren’t the only ways parents are borrowing to help their children pay for college. The Sallie Mae study found that of the 12 percent of parents who borrowed to pay for college, most were federal Plus loans — an average of $11,293 in 2016, followed by an average private education loan of $8,858.
Interest rates on Plus loans are typically fixed rates and are higher than HELOCs, and include an origination fee. HELOCs don’t have closing costs.
For people with bad credit or without a home, a Plus loan may be their only options. The federal loan has such benefits as loan deferment and flexible payment options.
Private lenders also offer college loans, though they’ll likely be higher than home equity loans. If you have good credit, a private lender may be able to offer a low rate.
Using your home as a piggy bank for expenses you plan to pay back has another advantage: tax deductions.
If you itemize your taxes, the interest paid on a HELOC or standard home equity loan is tax-deductible. These home equity loans are part of a mortgage, so if you’re already deducting interest from a home loan from your taxes, you can do the same with an equity loan to pay for college.
There are many ways to pay for a child’s college education, including traditional college loans. As a homeowner, you can use your home’s equity to your advantage. But just as you’d expect your child to study for an exam, be sure to do your homework to determine which loan is best for you.