Welcome to MainStreet's newest series. Each week, we will answer a real question from readers on education costs and how to pay for college. If you have a question, feel free to send it to firstname.lastname@example.org.
Q: "Does it make financial sense to use home equity loan money to pay for college expenses, even if savings do not meet the need and interest rates remain low?” – Kathleen S., San Diego, California.
A: There are two main types of loans: Those with fixed interest rates and loans with variable interest rates. Fixed-rate loans have the same interest rate throughout the term of the loan. The monthly payment doesn't change. Variable-rate loans have an interest rate that is pegged to a variable rate index, such as the Prime Lending Rate or the LIBOR index. Often the loan’s interest rate will change monthly, quarterly or annually, causing the monthly payment to change. Each 1% increase in the interest rate will increase the monthly payment by about 5% to 6%.
We are currently in an extraordinarily low interest rate environment, with the 1-month LIBOR index at 0.25% and the Prime Lending Rate at 3.25%. For comparison, the average 1-month LIBOR index from 1947 to the present is 4.17%, and the average Prime Lending Rate from 1947 to the present is 9.84%. Loans with variable interest rates are likely to start increasing again in a few years, making them potentially much more expensive than fixed-rate loans. Avoid borrowing from a variable-rate loan unless you are capable of repaying the debt within the next few years and fully intend to do so.
Families also find it easy to get confused when considering a variable-rate loan’s interest rate. Typically, a lender will disclose an APR based on the current interest rate. This rate, of course, will change over the life of the loan. It is also common to express the interest rate as a formula, such as 1-month LIBOR + 6%. Some students will misinterpret this as a 6% loan and be surprised when the interest increases substantially by the time they graduate. It is the sum of the LIBOR index and the 6% fixed margin, and the LIBOR index will vary over time.
On the other hand, you can get some really good deals on fixed-rate home equity loans. Fixed-rate $30,000 home equity loans currently have average interest rates of about 7.25%. That’s better than the 7.9% fixed rate on the Federal Parent PLUS Loan, though not as good as the 6.8% fixed rate on the Federal Unsubsidized Stafford Loan.
Both federal education loans and home equity loans can be deducted on your federal income tax return. You can deduct up to $2,500 in interest on federal and private student loans on your income tax return as an above-the-line exclusion from income. This means you can take this deduction even if you don’t itemize it. The home mortgage interest deduction, on the other hand, is only available if you itemize, and it lets you deduct the interest on up to $100,000 in home equity loans.
Another important difference to note is what happens if and when you default on the loan. If you default on a home equity loan, you can lose your home. If you default on a federal education loan, the government can garnish up to 15% of your income and offset your income tax refunds, but fortunately, it can’t repossess your child’s education.
Generally, it is better to borrow federal education loans first, as they are cheaper over the life of the loan. They are also more available and offer more flexible repayment options.