The cost of a college education has risen significantly over the last few decades. The average cost of college tuition and fees at public four-year universities has risen by 179.2 percent over the last 20 years. That’s an average annual increase of 9 percent! At the same time, financial aid has decreased at a rate of 6 percent, need-based grants are down 15 percent, and scholarship awards have declined by 24 percent.
If you’re struggling to pay for a child’s college education, you may be tempted to tap into your home’s equity with a home equity line of credit (HELOC). While using a HELOC to pay for college offers some benefits, including the potential for lower interest rates compared to student loans, there are also significant risks. Below are seven reasons to think twice before taking out a HELOC to pay for college.
1. Variable interest rates
Most HELOCs have adjustable interest rates, so the rate you’re paying now may not be the rate you pay in the future. If interest rates rise in the future, your monthly payment could increase significantly. This makes it difficult to plan — and virtually impossible to estimate how much you’ll pay in interest over time.
2. Risk of foreclosure
When you use your home as collateral, you risk foreclosure if you can’t fulfill your debt obligations. If an unexpected financial emergency arises and you’re not able to make payments on your loan, you could lose your home. Before committing to a HELOC, make sure you fully understand the risks and have enough emergency savings elsewhere to protect your home should something unexpected occur.
3. Minimum monthly interest payments
There are two primary time frames associated with a HELOC — a draw period and a repayment period. The draw period refers to the amount of time you have to borrow funds and is typically between five and 10 years. During this period, you don’t need to make principal payments, but you’re responsible for paying interest on your loan.
The repayment period is the time frame during which you must make monthly payments to both principal and interest. As noted above, the monthly payment amount will likely fluctuate, based on variable interest rates. Repayment periods typically vary between 20 and 30 years.
Remember that you’re paying interest throughout the entire life of the loan, during both the draw and repayment periods. The interest can add up to a significant sum over time.
4. Equity becomes unavailable for other purposes
Your home’s equity is a valuable asset. You can use it to purchase a new home, cover the cost of end-of-life care such as a nursing home, or pass it along to your heirs after your death as a financial legacy. Tapping into your home’s equity to pay for college means those assets aren’t available for other purposes, which can put your other future financial commitments at risk.
5. Prepayment penalties
Many lenders charge a penalty for paying back a HELOC faster than your established repayment terms. That’s because paying off your loan early means the lender receives less in interest over time. Before committing to a HELOC, make sure you fully understand all associated fees and potential penalties.
6. Closing costs
HELOCs often carry closing costs, which can quickly add up. Again, it’s important to fully understand all potential fees to determine whether a HELOC makes sense for your particular situation.
7. Ineligible for tax deductions
When used to pay for home improvements, the interest paid on a HELOC is typically tax-deductible. However, it’s important to know that using the money to pay for college doesn’t result in a tax deduction. In contrast, saving in a state 529 plan could both reduce your state income tax at the time of your contribution and offer tax-exempt investment growth.
Gene Gard, CFA, CFP, CFT-I, is a Partner and Private Wealth Manager with Creative Planning. Creative Planning is one of the nation’s largest Registered Investment Advisory firms providing comprehensive wealth management services to ensure all elements of a client’s financial life are working together, including investments, taxes, estate planning, and risk management. For more information or to request a free, no-obligation consultation, visit CreativePlanning.com.
