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How to Choose the Best Education Loans

Mark Kantrowitz

May 03, 2010

I want to know if it makes more sense to use money available in a home equity line of credit (2.74%) to pay some of my son’s college tuition or a private student loan (8.5%). I know the HELOC is a lower rate, but my concern is about getting into a position of having no equity left in my house if ever an emergency came up. — Marie P.

You should borrow federal first, as federal education loans are cheaper, more available and have better repayment terms than a private student loan or home equity line of credit (HELOC).

Both HELOCs and private student loans are variable rate loans, while federal education loans have fixed rates. Home equity lines of credit are typically repaid over 10-15 years and most private student loans are repaid over 15-30 years. You should consider that interest rates are currently unusually low, so the interest rates on variable rate loans are likely to increase significantly over the next few years. As a result, the variable rate loans will probably cost more over the life of the loan than a fixed rate federal education loan. Unless you are certain that you will be able to pay off the variable rate loans in full within the next few years, the federal education loans will be less expensive in the long term.

If you’ve exhausted your eligibility for federal education loans, however, home equity lines of credit and private student loans can help fill the gap. The 2.74% interest rate on your HELOC is a very good rate; the current average interest rate on a HELOC is almost twice as much. You must have excellent credit. Assuming a 15-year repayment term for both the HELOC and the private student loan, the 2.74% HELOC will save you about $5,500 in interest for each $10,000 borrowed over the life of the loan as compared with the 8.5% private student loan.

In most cases a HELOC will have a shorter repayment term than a private student loan. This may yield lower monthly payments on a private student loan than on a HELOC, even with the private student loan’s higher interest rate, but the total interest paid over the life of the private student loan will be much higher.

While saving money should be a primary consideration in choosing a loan, there are several additional factors that should be considered. As you noted, using the HELOC will decrease the equity in your home. You could end up owing more on your first mortgage and the HELOC than your home is worth. If you default on the HELOC, the bank can foreclose on your home, while an education lender cannot repossess your son’s education. Double check to make sure that the 2.74% rate is not a teaser rate that will increase a year after you tap into the line of credit. Also, if your remaining home equity drops too low, you might have to pay private mortgage insurance (PMI). Verify that the loan does not include a prepayment penalty; federal and private student loans do not have prepayment penalties.

Interest paid on both the HELOC and student loans can be deducted on your federal income tax return. The HELOC interest is deducted on schedule A and may be subject to the Alternative Minimum Tax (AMT). You cannot deduct interest on more than $100,000 of home equity debt ($50,000 if married filing separately). The student loan interest can be deducted as an above-the-line exclusion from income even if you don’t itemize, and is not subject to the AMT. However, the student loan interest deduction is capped at $2,500 in interest a year.

Other possibilities include a home equity loan, as opposed to a line of credit, or a cash-out refinance. Home equity loans often have a much higher interest rate, but the interest rate is fixed. However, the money from the home equity loan may hurt your son’s eligibility for need-based financial aid.

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