Is a 3.75% Cash-Out Refinance on a Mortgage Better than Federal Student Loans?
Expert advice on refinancing your mortgage to pay for college.
July 16, 2012
I have a daughter who will be attending college in the fall of 2013 (and a son in 2017). For various reasons, our savings are not sufficient to pay for college given the current costs that I see. As home mortgage refinance rates have dropped to their lowest levels in my lifetime (around 3.75%), I had the notion of conducting a refinance on our home mortgage and pulling some money out to help pay for college costs. However, the more I read the more mixed signals I get on just how wise this may be. I am 48 and still need to save more for retirement, and currently have a mortgage loan of around $250K, happily not underwater since we bought back in the late 1990s. But with rates so low, it seems a wise thing to consider pulling an additional $100K+ with the mortgage refi to help with tuition – much better than paying the steeper college loan rates. Do you think this is advisable? Will this hurt our chances for any needs-based financial aid? — John M.
It may make sense to refinance a mortgage if the new interest rate is at least one percentage point below your current interest rate. But the decision whether to borrow extra money to pay for college through a cash-out refinance isn’t as straightforward.
Mortgage interest rates are certainly at historic lows. According to Bankrate.com, the average 30-year fixed rate mortgage is about 3.75%.
But a 30-year mortgage has much too long a repayment term. For a 48-year-old parent, that would mean stretching out repayment until age 78. Parents should never borrow more for their children’s education than they can afford to repay in 10 years or by retirement, whichever comes first.
All debts, including education loans, credit cards, auto loans and mortgages, should be paid in full by the time the borrower retires. After retirement, there is no new income with which to make monthly loan payments, other than Social Security retirement benefits. There’s also the need to continue saving for retirement, especially during the last decade before retirement.
Assume, for the sake of argument, that one can obtain a 10-year mortgage with a 3.75% fixed interest rate. Borrowing an additional $100,000 on top of a $250,000 mortgage increases the loan payments by about $1,000 a month or $12,000 a year. Repayment on a mortgage begins immediately, so by the time the second child graduates, the parent borrower will have made 9 years of payments, or a total of $108,000. So purely from a cash flow perspective, it is more efficient to use the money to pay for college directly instead of using it to make the payments on a larger mortgage. If a student’s parents don’t have the money to make the higher mortgage payments, they shouldn’t be borrowing to pay for college, and instead should send their children to lower cost colleges.
Parents who cannot afford to pay the college bills all at once may wish to consider using a tuition installment plan. A tuition installment plan allows the family to spread out the college bills into 9 or 10 equal monthly installments for an up front fee that is typically less than $100.
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.
Mortgages come with additional risks as compared with federal education loans. If you default on a mortgage, you can lose the home; if you default on a student loan, the lender can’t repossess your education. However, student loans are almost impossible to discharge in bankruptcy, and the federal government has very strong powers to compel repayment on federal education loans.
But federal education loans also offer more options for repayment relief than mortgages. Payments on federal education loans can be deferred while the student is in school and for six months after graduation. If the borrower encounters financial difficulty, federal education loans are eligible for up to 3 years of economic hardship deferments and up to 5 years of forbearances. Federal education loans are also eligible for graduated repayment and extended repayment. Federal student loans (but not Parent PLUS loans) are eligible for income-based repayment and public service loan forgiveness.