Is a 3.75% Cash-Out Refinance on a Mortgage Better than Federal Student Loans?
July 16, 2012
A key problem with a home equity loan or cash-out refinance is the up-front disbursement. This yields a lump sum in advance, years before the money is needed. The interest rate may be very low, but the borrower will pay interest on the loan for many years before the money is needed to pay for college bills. Interest begins accruing from the date of disbursement.
The family could defray the cost of the debt by investing the proceeds from the cash-out refinance. However, the money must be invested in a low-risk investment where there is little risk of loss to principal, which necessarily means a low return on investment. For example, a 2% return on investment might yield as much as $8,750 after taxes. That’s the total return for investing the mortgage proceeds before it is used, not per year.
Another problem with a cash-out refinance is that the money will be counted as a parent asset until it is used, reducing eligibility for need-based financial aid. $100,000 in the bank will reduce aid eligibility by as much as $5,640. (Assuming that 1/8 of the funds are used each year, the maximum cumulative loss of aid eligibility is $25,380.) Normally the net worth of an asset is reported on the Free Application for Federal Student Aid (FAFSA), where the value of the asset is reduced by any debts secured by the asset. However, the mortgage is secured by the home, not the proceeds from the cash-out refinance, and the family’s principal place of residence is not reported as an asset on the FAFSA so its value cannot be reduced.
On the other hand, a $250,000 mortgage suggests that the family income is high enough that the family might not qualify for much need-based aid other than low-cost loans.
A home equity line of credit (HELOC) can avoid this problem by allowing the family to tap the line of credit only when needed, but most HELOCs have variable rates, not fixed rates. So borrowers of a HELOC aren’t able to lock in current low rates. Variable rates are likely to increase in a few years by as much as interest rates decreased at the start of the credit crisis, or about 6%. Accordingly, the equivalent fixed rate for a 10- or 15-year variable-rate loan is currently about 4 percentage points higher than the variable rate.
The interest on mortgages and education loans can both be deducted on the borrower’s federal income tax returns, but in different ways. Up to $2,500 in student loan interest can be deducted as an above-the-line exclusion from income. This deduction can be taken even if the taxpayer does not itemize. The home mortgage interest deduction, on the other hand, requires itemization. The interest on up to $100,000 in home mortgage debt used for college costs can be deducted. However, this deduction is subject to the Alternative Minimum Tax (AMT) and so may be reduced or disallowed entirely. At a 3.75% interest rate the amount borrowed must exceed $66,666 for the value of the mortgage interest deduction to exceed the value of the student loan interest deduction. Even if the family borrows the full $100,000, the added savings is only $313 during the first year (assuming that the borrower is in the 25% tax bracket) and only about $5,000 over the life of the loan.