Deciding to use the equity in your home to pay for college

If you are preparing to send a child to college, the cost may seem excessive. A home equity line of credit (HELOC) or home equity loan could help you pay for it, but before you tap into your equity, there are a number of factors to consider.

Key statistics on the cost of college and housing

• According to the College Board, the average annual cost of a public university is $10,740. In comparison, the annual cost of a non-public university is $27,560. Private universities cost about $38,000 per year.
• According to Black Knight, in April 2022 the average owner had equity of $207,000.
• According to CoreLogic, the average owner earned $64,000 in equity between the first quarter of 2021 and the first quarter of 2022.
• According to TransUnion, HELOC sales increased by 31 percent at the end of 2021 compared to the end of 2020, and sales of new home equity loans increased by 13 percent.

What is home equity and how is it used?

Home equity is the difference between the value of the home and the mortgage debt. For example, if mortgage debt is $170,000 and the house is worth $400,000, home equity is $230,000.

Homeowners accumulate equity by paying mortgage payments and when the value of their property increases. The increase in equity has been significant due to the booming housing market: in fact, according to the Federal Reserve, U.S. home equity recently reached a record $27.8 trillion.

Homeowners draw on their net worth to meet a number of major expenses, including renovation projects, large medical bills, and higher education expenses.

When you use your home equity to pay for higher education, you may qualify for a home equity loan, a type of second mortgage that provides a lump sum to be used for tuition, room and board and all other expenses. The loan is repaid in monthly installments at a fixed interest rate for a set period, which can sometimes be as long as 30 years.

Instead of a mortgage, one can opt for a LOC, which works more like a credit card. HELOC rates are variable and you can access the money when you need it. A HELOC may be more appropriate for some small college expenses, such as books, food and other everyday expenses.

HELOCs and mortgages versus student loans

While the equity in your home can be used for any purpose, student loans are only for covering graduation costs.

Student loans can come from federal or private sources. Private loans can have very high rates, while federal loan programs offer lower fixed rates. The loan can be in the name of the student or his or her parents.

HELOC and home equity loans have the disadvantage of putting your home at risk. Another disadvantage: You will not be able to deduct the interest from your taxes if you use the funds to pay for your studies. However, both options have advantages, including more repayment options and the ability to qualify even with bad credit.

The advantages of student loans

• HELOC loans and home equity loans
• Possibility of debt forgiveness for some borrowers.
• Ability to deduct up to $2,500 per year in interest.

Disadvantages of student loans

• Interest rates can be excessively high.
• Debt can delay other financial goals (such as buying a home).
• Repayment options apply only to certain borrowers.

Advantages of HELOCs and mortgages

• HELOCs offer greater flexibility (you borrow only what you need).
• Often the loan can be approved even if you have bad credit.
• You can choose from several repayment options.

Disadvantages of HELs and home equity loans

• The home is collateral
• They are not tax-deductible (unless it is a home equity loan used for certain renovations).
• Limited borrowing capacity; most lenders require you to keep 20 percent of the equity in your home.

Should I use my home equity to pay for my education?

There is no single answer to the question of whether a mortgage is the right choice to cover education costs. You need to think about how much you need, your ability to incur other debt, your plans for the future, and the cost of a mortgage compared to other financing options. Ask yourself:

What are the student loan options?

There are two types of student loans: federal student loans, which involve borrowing from the government and account for the majority of all student loans, and private student loans, which come from for-profit institutions. Federal student loans have fixed interest rates, lower for undergraduates and higher for parents and graduates. Private student loans can have fixed or variable interest rates. Students rarely have high credit, so if your children take out a loan without your co-signer, their interest rate may be much closer to that of credit cards. Repaying this loan can be much more difficult than writing a thesis or taking a final exam.

What are the current rates of home equity loans?

Although rates on HELOCs and home equity loans have historically been lower (lenders are willing to offer better terms because the home is pledged as collateral), they have risen rapidly, almost at the same rate as current student loan rates. For the same cost of financing, it may make more sense to opt for a student loan at this time.

Are you approaching retirement?

Taking out a loan to finance a child's education is not just about his or her future; you also need to think about the big picture. If you are approaching the end of your working life, you will need to focus on your budget to make sure you can pay off your debt (whether a mortgage or a student loan) and at the same time cover your expenses.

How much of your tuition do you need to cover?

If you have more than one child going to college, one mortgage may not be enough to cover the cost of tuition, housing and board for both children, unless you own a very expensive home and have a lot of equity. You may need to take out several mortgages, both mortgage and student loans, to pay for everything.

What does the future hold for your student?

It may be too early to know what your child will do after graduation, but if he or she already has a clear career plan, he or she may be able to benefit from debt relief in the future. Teachers, civil servants and employees of some nonprofit organizations may have some of their debt forgiven after a certain period. In the case of a mortgage, however, you will have to repay every single dollar.

Should you take advantage of this opportunity to help your children grow up?

When your children start college, it may be a good time to help them figure out what they need to do to invest in their higher education. By taking out a traditional student loan in their name, you can instill a greater sense of responsibility and ask them to take classes, get work experience and find a good job to pay back all that money.

The risks of a student loan

• You put your home at risk. When you take out a home equity loan, your home is put up as collateral. If you have problems and can no longer pay your monthly payments, the mortgage lender can foreclose on your home.
• The value of the property may decrease. Losing home value may seem impossible at the moment, but prices do not always follow the rapid upward trajectory we have seen in recent years. (If the value of your home drops significantly, you may end up with more debt than value.
• Increase your debt. Increased debt can put a strain on your finances and increase stress. You need to make sure you can sleep soundly knowing that your bills are increasing.

How can I use my home equity to finance higher education?

If you think using your home equity is the way to go, here's how to get started:

1. Estimate the value of your home. The value of your home is not the amount you paid to buy it. In the past two years, house prices have risen rapidly. Estimate the value of your home to get an idea of the real value of your assets.
2. Know your credit rating (and take steps to improve it, if necessary). If you succeed in getting a home loan with bad credit, you will not qualify for lower rates. Check your credit rating before you apply. Most lenders reserve the best loan terms for borrowers with a score of 740 or higher.
3. Compare lenders. Consider at least three real estate lenders and compare rates, fees, terms, maximum loan amounts, credit requirements and more. Also consider other features you may need later, such as the ability to convert an adjustable-rate HELOC to a fixed-rate real estate loan.

Alternatives to using equity for education

Putting home equity at risk to finance education can be risky. If using equity does not seem like the right choice, consider the following alternatives for finding the funds you need.

• Grants and scholarships - While your child is attending college, ask him or her to apply for grants and scholarships. Many universities offer merit-based scholarships that reward academic achievement, but other opportunities for financial assistance also exist. Some scholarships are modest, on the order of $500, but can cover the entire bill. Discover's scholarship tool includes more than three million scholarships for all types of students.
• Financial Aid - Be sure to fill out the FAFSA (Free Application for Federal Student Aid), which can help your student get financial aid based on your income.
• Work-study programs - Supervising the computer lab, grading papers, organizing campus visits: many universities offer work-study positions to students who qualify for financial aid. Students earn at least the federal minimum wage (and in some cases much more), and the money can help cover some of the university's expenses.
• Payment Plans - Many institutions offer monthly payment plans, which can be easier to manage than a large check at the beginning of the semester.

Conclusion

Using a HELOC or mortgage to pay for college is not for everyone. Although they have their advantages, home loans are becoming more expensive as interest rates rise. Don't forget to compare the monthly repayments of a home loan with those of a student loan. Remember that a home loan, which can have a particularly low interest rate for 12 or 24 months, can be useful for small expenses such as paying for books and supplies. If you decide to use the equity in your home to pay for your child's education, it is essential that you make sure your child understands what it means for you as a parent to take on more debt. Your child may leave home, but you will stay. So they need to understand that your investment is worth it.