Paying for college can be a challenge for many families. Even those who are diligent savers may still need more funds after applying available savings, scholarships and grants and maximizing federal direct student loans. In such cases, many parents consider additional loan options like private student loans, the federal Parent PLUS loan or a home equity loan to fill the gap.
Home equity loans allow homeowners to take out a line of credit against the value of their home beyond what they owe on their primary mortgage. Unlike a cash-out refinance, a home equity loan doesn’t replace the mortgage you currently have, and it allows you to borrow the exact amount you need to cover the cost of college, in some cases without having to pay closing costs.
In recent years, property values in many markets have risen dramatically, putting many homeowners in a position to use this financing vehicle.
At the same time, higher interest rates on the Parent PLUS loan could make alternative financing options, like private student loans or home equity loans, more attractive to many families.
The U.S. Department of Education recently raised the Parent PLUS loan interest rate to 6.28% for loans first disbursed on or after July 1, 2021 and before July 1, 2022 — up from 5.3% the prior year. Current home equity loan rates generally range from about 3% to 12% depending on the lender, loan amount and creditworthiness of the borrower.
[READ: 4 Things Borrowers Don’t Always Know About Parent PLUS Loans.]
Here are some of the pros and cons of using a home equity loan instead of a Parent PLUS loan to pay for college.
Pros of a Home Equity Loan to Fund College
Creditworthy homeowners may be able to get home equity loans with a better interest rate than the Parent PLUS loan. The Parent PLUS has the same fixed interest rate for every borrower regardless of credit history, but those with good credit can often find better interest rates on a home equity loan.
Lower interest rates can mean that parents may have lower monthly payments and save money over time as their student’s loan is repaid.
For example, in 2021, the average Parent PLUS loan borrower owed nearly $29,000. The loan’s origination fee currently is 4.228%. At 6.28% interest, the repayment for $29,000 under a standard 10-year repayment plan would be about $326 per month. That includes about $10,126 paid in interest. Adding the total of about $1,226 in origination fees that were automatically taken from each loan disbursement would make the total cost of the Parent Plus loans about $40,350.
If that same parent borrowed a home equity loan for the same amount with a 5% interest rate, the payments would be about $308 per month over 10 years. For a loan with no origination fees, the total cost of the loan would be $36,960, or more than $3,000 cheaper than the Parent PLUS loan.
Be sure to look for home equity loans that charge no closing costs or annual fees. Also keep in mind that better interest rates will depend on your credit score.
[READ: Why Your Creditworthiness May Matter for Student Borrowing.]
In addition, home equity loans also can be the more tax-efficient option for parents. On federal income tax returns, a parent can deduct up to $375,000 in interest annually for qualifying home equity loans — or $750,000 if filing jointly — compared to a maximum of only $2,500 annually for qualifying Parent PLUS loans.
Risks of a Home Equity Loan to Pay for School
If you can save money and reduce your monthly payments by taking out a home equity loan over a Parent PLUS loan, paying for college with a home equity loan may seem like a no-brainer. But parents should be aware that there are more risks associated with these loans.
First, when parents borrow against their homes, they are essentially gambling their homes to pay for school. That’s because when you take out a home equity loan, your home is put up as collateral. If a loan isn’t repaid, your house can be repossessed.
There is also the risk of becoming “upside down” on the home if property values decrease. 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 end up with more debt than equity.
Other Student Loan Considerations for Parents
In terms of repayment, neither the home equity loan nor the Parent PLUS loan is typically eligible for the generous income-driven repayment options offered for some federal direct student loans. Currently, payments and interest on most existing Parent PLUS loans are automatically suspended through May 1 as part of the pandemic-related CARES Act enacted in 2020.
[READ: Can I Buy a Home If I Have Student Loan Debt?]
Families with good credit looking to save money may also be able to find lower interest rates on private student loans, which may carry fewer risks, particularly because they typically do not use homes as collateral.
Also, most private student loans are made to the student, who will benefit from the education, with a parent possibly listed as an endorser, which is a type of co-signer. This can prevent parents from being buried by college debt as they near retirement.
Despite the cost rising each year, college remains one of the best investments that families can make in the future. Your best resource to navigate the different loan options is your college or university’s financial aid office. The staff there will be able to explain all your options and how to apply for different types of student loans.
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Should Parents Use a PLUS or Home Equity Loan to Help Pay for College? originally appeared on usnews.com
