Homeowners

Should You Use a Home Equity Loan to Put Your Kids Through College?

A college degree is a milestone to be proud of, but it often comes with hefty debt. 

The average federal student loan debt is now nearly $40,000, according to the Education Data Initiative. This can delay other life milestones, such as buying a home, starting a family, or saving for retirement.

But there may be another way to foot the tuition bill. Parents of college-bound kids, who already own a home and have built equity in their property, may want to consider a home equity loan.

These can include Home Equity Lines of Credit (HELOCs), second mortgages, and cash-out refinances to cover college costs. These loans may offer lower interest rates than private student loans.

“If you’re about to have kids in college and you haven’t been saving since they were a kid, there are ways to make it happen,” said Mychael Fields, senior sales manager at New American Funding. He’s based in Novi, Mich. “[You may be able to] take equity out.”

When a home equity loan might make sense for college tuition

One reason to choose a home equity loan over traditional student loans comes down to interest rates. While rates for federal student loans for undergraduates may be comparable to home equity loans, private student loans offered by banks, credit unions, and other lenders can climb well into the double digits.

Home equity loans are tied to the value of your property, which typically keeps rates lower.

Tapping home equity won’t affect your child’s financial eligibility for financial aid since equity in your primary home isn’t counted as an asset. That means borrowing against it won’t reduce the amount of aid your family might qualify for to help pay for school. 

Ultimately, choosing between federal student loans or home equity loans comes down to your family’s personal financial situation and the amount of equity you’ve built.

To be eligible for a home equity loan, homeowners need to have at least 15% to 20% of equity in their home. The equity can come from a combination of home appreciation and paying down the loan.

Lenders will typically allow homeowners to borrow up to 75% to 80% of the home’s equity. So, on a $500,000 home with a $300,000 mortgage, you might be eligible to borrow up to $100,000.

What kinds of home equity loans are available?

There are three main ways to access home equity. Choosing the right one depends on how much you need, how quickly you need it, and how predictable your costs are.

Home Equity Line of Credit (HELOC): A HELOC works much like a credit card. You’re approved for a certain amount. You can draw on that line of credit as needed during an agreed upon period. Then you pay back only what you borrowed over time. Since college costs can vary a bit from year to year, the flexibility of a HELOC can be an advantage. Fields generally recommends HELOCs for college since the cost of living, books, and tuition often change annually.  

“If you don’t know every year what it’s going to cost, it’s nice to have a Home Equity Line of Credit,” Fields said. “You have a defined amount. But tuition goes up, it’s nice to have that flexibility.”

Cash-out refinance: A cash-out refi replaces your existing mortgage with a new, larger one. Then you pocket the difference. These can be a good fit when you have a specific, known dollar amount you need up front. In some cases, that could be to cover college debt.

Fields once helped a family secure a cash-out refinance to pay off expensive debt incurred from one year at a private, out-of-state school.

One point of caution: if you’ve already paid down many years of your mortgage, a cash-out refi that resets you to a new, 30-year term can cost you more in the long run. Fields advises borrowers to choose a 15- or 20-year loan term instead if they can afford the payments.

Second mortgage: A second mortgage is a separate loan taken out on top of your existing mortgage, using your home as collateral. These loans may make sense for those who locked in a low mortgage rate they are reluctant to give up.

While HELOCs are technically a form of second mortgage, a traditional second mortgage delivers a lump sum.

Fields said he typically reserves this option for financial emergencies, since the loan may come with higher costs and places a second lien on the property until the loan is paid off or the home is sold.

Risks you need to understand before tapping home equity

Tapping your home equity to pay for college is not a decision to make lightly. If your financial situation changes and you can no longer make payments on the new loans, your lender can move to foreclose on the property in the worst-case scenario.

One way to check if you’re taking on a manageable amount of debt is to watch your debt-to-income (DTI) ratio. That’s the percentage of your gross monthly income that goes toward debt payments.

“If your debt-to-income ratio is already high, taking out an additional loan on your equity just further worsens that strain,” said Fields.

Be sure to do your homework and weigh all of your options before committing to pricey tuition.

“Do your research first and don’t act out of desperation,” Fields said.

Mychael Fields NMLS # 339585