Until the housing market collapsed in 2007, home equity loans were a popular alternative to federal parent PLUS loans for parents looking to finance their children’s college education. These home loans allow homeowners to take out a line of credit against the value of their homes beyond what they owe on their primary mortgage.
When house prices were at their peak, these financing vehicles offered low interest rates and were easily accessible. But after the housing bubble burst, equity loans were out of reach for the many homeowners who owed more on their mortgages than the home’s worth.
As the U.S. slowly recovers from the recent economic meltdown, home prices are returning to pre-recession levels. So should parents start shunning the PLUS for home equity loans instead? The answer: Not so fast.
[Think hard before borrowing money for or with your student.]
The Risks
Paying for a child’s college education with a home equity loan may seem like a no-brainer for some parents, but there are more risks with these loans than with parent PLUS loans.
For starters, when you borrow a home equity loan, your home is being put up as collateral. If a loan isn’t repaid, your house can be repossessed. Many people learned this the hard way. From 2007 to 2011, there were more than 4 million completed foreclosures. When parents borrow against their homes, they are essentially gambling their homes to pay for school.
There is also the risk of becoming “upside down” on the home. This occurs when more money is owed on the home than it is worth. If the housing market weakens and your home value drops, you could be left with more debt than equity.
A home equity loan could also jeopardize your child’s eligibility for some forms of need-based financial aid. That’s because the federal government and the college could count the money received from a home equity loan as income when they calculate your expected family contribution from the Free Application for Federal Student Aid.
[Get four strategies for repaying federal parent PLUS loans.]
In terms of repayment, neither the home equity nor the parent PLUS loan are typically eligible for the generous income-driven repayment options offered by federal student loans. Although, as we’ve outlined in the past, parent PLUS loans can obtain access to income-contingent repayment if they’re consolidated under the federal direct loan program.
Some home equity loans do offer the option to make interest-only payments for up to 10 years, which may sound like a great option when budgets are tight. The consequence, though, is that payments after the first 10 years will be much higher and many parent borrowers will be nearing retirement at that point. You could be forced to work longer than you’d intended to pay off that debt before retirement.
The Benefits
Home equity loans beat out parent PLUS loans on interest rates. In 2015, the interest rates on home equity loans are hovering around 5 percent, which is lower than the parent PLUS loan interest rate of 6.84 percent for the 2015-2016 academic year. Once the 4.2 percent origination fee — which home equity loans rarely charge — is added in, the home equity loan looks like a much cheaper option.
As an example, the average parent PLUS loan holder in the 2014-2015 academic year borrowed approximately $31,000 by the time of their child’s graduation. At 6.84 percent, the payment for a standard 10-year repayment plan would be about $355 per month and $11,800 would be paid in interest. The origination fee charged would be about $1,300, making the total cost of borrowing the loan more than $44,000.
[See how income-driven student loan repayment plans can cost more.]
If that same parent borrowed a home equity loan for the same amount with a 5 percent interest rate, the payments would be about $330 per month over 10 years and slightly less than $8,500 would be paid in interest. With no origination fees, the total cost of the loan would be less than $40,000 — more than $4,000 cheaper than the parent PLUS loan.
Home equity loans also can be the more tax-efficient option. While filing federal tax returns, parents can deduct up to $100,000 in interest annually for home equity loans, but only $2,500 for parent PLUS loans.
As with many borrowing decisions, choosing between a home equity or the parent PLUS can be a trade-off between lower costs over the life of the loan vs. safer repayment options should you face financially tough times. Let your own financial situation, both now and what you can reasonably predict it will be in the future, dictate your decision.
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Decide Whether to Use Home Equity, Parent PLUS Loans To Pay For College originally appeared on usnews.com
