Is a Home Equity Loan for College the Best Idea Ever?

Here’s a little-known fact: There’s no law that says you have to pay for college using student loans. In fact, I encouraged everyone I came in contact with during their college tours to get as creative as possible as they carefully mapped out how to pay for college.

As interest rates drop, it’s natural to think that there may be other options to pay for college. Only one percent of parents used a home equity loan to pay for college, according to a 2015 Sallie Mae study called How America Pays for College.

But what if you did tap into your home equity to pay for college? It’s worth exploring! However, also know that it might not be the right fit for you at all. Let’s explore your options. 

What is Home Equity?

The words “home equity” sound complicated, but it’s actually really simple — home equity refers to the amount of your home that you actually own. As you make payments on your mortgage, you reduce your principal, the amount you owe on your loan. As you do that, you build your home equity. You only own the percentage of your home that you’ve paid off. Your mortgage lender owns the portion of your home until you pay off your loan.

See, simple! Are you with me? Here’s an example:

Let’s say you bought your house for $100,000 with a 20% down payment of $20,000. You automatically get $20,000 in equity on closing day. Every mortgage payment helps you build more and more equity, as long as your home value doesn’t drop. 

What happens when you’ve fully paid off your mortgage? That’s right — you’ve got 100 percent equity in your home, and that’s a beautiful thing.

How Do You Determine Your Home Equity?

Don’t know how much equity you have? That’s okay. I didn’t really know how much equity we had in our home, either, till we refinanced. The mortgage payment was one thing around my house that actually took care of itself — unlike our kids, garden and landscaping. We had it set up on autopay and it truly didn’t need a lot of attention. (I know, not the best approach. It’s always good to know exactly what your home equity is at any given time.)

Here’s how to figure out your home equity:

1. Log in to your lender’s website or call your lender to determine how much you owe.  
2. Figure out how much your home is worth. Subtract your loan balance from your estimated home value. For example, let’s imagine you owe $100,000 on your home and you believe your home is worth $200,000. Subtract $100,000 from $200,000. This means you have an estimated $100,000 in equity in your home.
3. Keep making your monthly payments if you want to continue to build your home equity. Simple, huh?

Types of Home Equity Loans and Lines of Credit

Resist hitting the snooze button here. Let’s very briefly go over a few points on home equity loans, cash-out refinances and home equity lines of credit (HELOC).

Home Equity Loan

A home equity loan is exactly the same thing as taking out a second mortgage. You repay the loan with equal monthly payments over a fixed time period (just like you did with your original mortgage) and you receive the money as a lump sum amount. Your home is used as collateral to protect your lender in case you’re unable to pay back the money you owe and you default on your loan.

The amount you can borrow usually depends on your lender, but is usually limited to 85 percent of the equity in your home. The actual amount you’ll be able to get also depends on your income, debt-to-income ratio, credit history and the market value of your home.

Cash-Out Refinance

A cash-out refinance is different from a home equity loan. To put it simply, you borrow more than you owe on your mortgage and pocket the difference.

When you get a second mortgage, you add another payment to your list of payments every month. A cash-out refinance is different — you pay off your old mortgage and replace it with your new mortgage.

Here’s how it works. Imagine your home is worth $150,000 and you’ve paid off $50,000. This means you still owe $100,000 on your home. Let’s also say that you want to use $10,000 to pay for college.

A cash-out refinance lets you take a portion of your equity and add that $10,000 to your new mortgage principal. In other words, your new mortgage would be worth $110,000 — the $100,000 you still owe plus the amount you want to borrow for college. You’ll get the $10,000 a few days after you close on your new refinance.

Home Equity Line of Credit (HELOC)

A HELOC is a second mortgage just like a home equity loan. However, you don’t get your money in a lump sum like you do with a home equity loan. Instead, think of a HELOC more like a credit card. HELOCs allow you to draw from your predetermined loan amount as you need it.

You can draw from your HELOC between five and ten years and just need to pay interest on the money you take out. Let’s say you have $50,000 equity in your home. You can take out money as you need it for college during the draw period and will only pay interest on the money as you take it out.

When do you pay off the loan principal? Not until the end of your draw period. The repayment period usually lasts 10 to 20 years and you pay both interest and principal on the amount you borrow. 

Another difference between HELOCs and home equity loans is that the rate is adjustable over time, which means it changes over time depending on the prevailing interest rate.

Mouse Traps

Ha ha, do you like that section header? I named it that because we currently have a mouse in our van and even worse, my husband can’t find it. I am driving a van that has a mouse currently living in it. I bet it has babies. I bet it has a whole brood of baby mice. 

It’s horrifying. I keep expecting a mouse to jump onto my lap as I’m traveling 55 miles per hour down the highway. I’ll be holding a mug of tea, my mug will fly out of my hands and I’ll wrench the steering wheel in horror and crash into the ditch, sending the mouse and everyone in the car flying through the air with second-degree tea burns.

Anyway, I digress. 

Cons of Tapping Home Equity to Pay for College

Even if a home equity loan offers a lower interest rate than private loans or even federal loans, a low interest rate isn’t the only reason to go after a home equity loan. Here are some major downsides to using a home equity loan to pay for college:

• Your home is used as collateral. What happens if you can’t pay back the loan? Your house can be whisked away by the bank — just for a college education. That’s a pretty big risk.
• Home equity loans don’t offer much flexibility. Federal student loans offer forbearance and deferment options. In other words, your student may be able to temporarily stop making loan payments. (The main difference between the two is if that deferment means no interest will accrue on your child’s loan balance. Forbearance means interest does accrue on your child’s loan balance.) In some cases, federal student loans can be completely forgiven — your child doesn’t have to pay them back at all. 
• Interest rates might not be lower. Compare student loan interest rates to home equity loan interest rates. Which ones are higher? 

Pros of Using Home Equity to Pay for College

• Ease. As long as your credit score and debt-to-income ratio is good, tapping into your home equity is fairly easy to do. Note: It usually takes 30 to 45 days to get a home equity loan, HELOC or cash-out refinance, though that depends on the lender.
• Tax benefits. Interest is tax deductible on home equity loans, HELOCs or cash-out refinances.
• Interest rates might be lower. They might be lower than private student loans. However, it’s worth looking into if a private student loan carries a 5.25 percent interest rate and you can get a home equity loan with a five percent interest rate. Even a quarter of a percentage can make a difference.

Other Things to Consider

Having a lot of equity in your home isn’t a guarantee that you’ll get a home equity loan, cash-out refinance or HELOC. You still need a decent debt-to-income ratio and credit score to be able to tap into your home equity and you’ll also need to get a home appraisal. I’ll briefly chat about debt-to-income ratio and credit score and how that can impact your ability to tap into your home’s equity.

Your Debt-to-Income Ratio

Lenders use something called your debt-to-income (DTI) ratio to determine how your monthly debt payments compare to your monthly income. Your DTI should be around 43 percent. You can calculate it yourself: 

DTI = Total Monthly Debt Payments / Gross Monthly Income

1. Add up all of your monthly debt payments, including your primary mortgage, student loans, car loan, credit card bills, alimony, child support, etc.
2. Divide the sum by your gross monthly income (your income before taxes and deductions).
3. Multiply by 100 to find your DTI.

Here’s an example. Imagine all your debts total $2,000 and you earn $5,000 a month before taxes, your DTI would be 40 percent. 

Your Credit Score

Lenders will also be interested in learning more about your credit score. Simply put, if you want to obtain a home equity loan, your credit score should be 620 or higher. However, if other qualifications (like your DTI) are higher, a credit score a little lower than this might be overlooked. However, the higher your credit score, the lower your interest rate will be.

Next Steps

Reach out to various lenders to determine whether one of these options are right for you. Ask about:

• Closing costs
• Annual fees
• Home appraisal expenses
• Taxes
• How long it will take to pay off your loan
• Length of time to get a home equity loan, home equity line of credit (HELOC) or cash-out refinance
• Private student loan options
• The total cost you’ll need to repay

You don’t need to stick to the same lender that provided your primary mortgage. Reach out to other lenders (challenge yourself to look into five!) because others might offer better interest rates and terms.

Determine Whether to Tap into Home Equity for College

I tell everyone who will listen that I recently refinanced my home. The interest rate I got was so low I couldn’t believe it — I didn’t think interest rates could possibly get lower than 4.25 percent — our original interest rate. Now I’m the proud owner of a 2.25 percent interest rate mortgage!

So. Here’s the problem. You might start snoring hard every time you hear the words “home equity.” But don’t! It’s easy to plod along, which is what my husband and I were doing until I heard a podcast host say, “You need to look into refinancing. It could change your life.”

I stopped, mid-plod. “Whaaaaa???”

Now, a refinance is different from a home equity loan. But the point is, it’s easy to get complacent and not look into all your options. If I hadn’t listened to that podcast, we’d still be stuck with an interest rate that wasn’t right for us.

Do some careful searching to make sure that tapping into your home’s equity is the right way to go. Sure, interest rates might be lower than private student loans, but remember, your home is on the line.