Tapping home equity for college

Parents get flexibility, financial-aid breaks, but student loans can offer better rates

Some parents joke about taking out a second mortgage to pay for the children's college education.

Others actually do it.

Diminutive interest rates have families wondering if tapping home equity to pay for tuition is a good idea. About 5 percent of the money borrowed through home-equity lines of credit in recent years has been used for education, the Consumer Bankers Association reports.

"Education is a small percentage, but that is growing as parents are finding that college expenses have gone sky high and the federal student-loan programs are not covering those costs," says Krayton Davis of nBuy Associates in Richmond, Va., which runs the SayLending.com network of websites.

Home-equity lines of credit have a number of advantages over other kinds of loans, Mr. Davis says. Rather than having to renew a loan every year and pay the related fees, you can typically draw on a home-equity line whenever you need it over a five- or 10-year period, and the variable-rate interest is added into your monthly mortgage bill.

It's also easy to set up an account that students can access and parents can monitor online, he says.

Another choice is taking a home equity loan, a lump sum of money at a fixed interest rate. This might position parents better in the financial-aid game. Formulas for federal aid don't take account of home values. But many private colleges require a financial-aid form that counts 3 to 5 percent of assets, including home equity, when calculating how much parents are expected to contribute.

A loan that reduces home equity by $20,000, for instance, could qualify the family for an extra $600 to $1,000 in aid.

"It isn't going to be a big-time difference, but it could be some difference," says Don Emmons, dean of admissions and financial aid at Hobart & William Smith Colleges in Geneva, N.Y.

But home equity is not necessarily the best source for closing gaps in the college fund, financial planners and tuition counselors say. Besides the risk of losing the house in a default, it might cut too deep into the retirement nest egg.

"Many times, home equity is your emergency fund, and if you use it for education you lose that flexibility," says Claudia Schutz, senior vice president of Academic Management Services (AMS) in Swansea, Mass., which sets up payment plans for families.

Comparably low interest rates are available, she says, in the form of a federal PLUS loan (Parent Loan for Undergraduate Students). The interest rate for this year was set on July 1 at 4.22 percent.

While some variable rates for home equity loans may be slightly lower, Ms. Schutz says, the advantage of the PLUS loan is that once a student starts to make payments, the loan can be consolidated at a fixed rate (currently it would be rounded up to 4.25 percent). Most fixed rates for home-equity loans are higher, she says.

For a range of student loans, monthly payments are deferred until six months after college graduation. But for PLUS loans, parents generally have to start paying back as soon as all the tuition for the year is disbursed to the school, which typically happens by the beginning of the second semester. That hasn't deterred parents, though. PLUS loans to AMS clients more than doubled between 2002 and 2003.

As for tax considerations, $2,500 in education-loan interest can be deducted if you fall within certain income limits, says John Sestina, a financial planner in Columbus, Ohio. Interest on home equity loans, on the other hand, is supposed to be deducted only if it's used to improve the house. (In practice, he and other experts say, it's often written off regardless of how the money is spent.)

In the end, each family has to decide how much debt is reasonable for them to carry into the future. If parents haven't saved enough, Mr. Sestina suggests, they might want to sit their children down and talk about paying a certain amount of college expenses on their own.

"We're headed for a bit of a crisis," Sestina says, "because [baby boomers] haven't saved enough money for their retirement, and they are burdening themselves even further by trying to fund a college education they cannot afford."