With mortgage interest rates at or near record lows, should I get a home equity loan or cash-out refinance of my mortgage and use the proceeds to put a lump sum into my state’s 529 plan?
Borrowing against the equity in your home and putting the proceeds into a 529 plan may look like a smart thing to do, especially given today’s record low mortgage interest rates and high stock-market returns.
Generally speaking, if the value of your 529 plan increases at a rate in excess of the interest rate on your mortgage, you end up ahead. It becomes even more attractive when the earnings on your 529 contract are tax-free.
However, there are a few caveats that you need to consider before jumping at this opportunity:
- Home mortgage loans must be paid monthly, but you can’t withdraw money from the 529 plan for this purpose without incurring tax and penalty. Make sure your cash flow will handle the higher monthly payments.
- Consider all borrowing costs when borrowing on the equity in your home. Closing costs can be substantial.
- The Tax Cuts and Jobs Act of 2017 limited the deduction for home mortgage interest to the first $750,000 of a mortgage for new mortgages starting in 2018. The interest on home equity loans and lines of credit, however, is no longer deductible from 2018 through 2025, inclusive, unless the loan is used to renovate or improve the home. If you use the home equity loan or HELOC for living expenses, such as paying for college, the interest is no longer deductible. (The student loan interest deduction, on the other hand, is still available.)
- Interest on home-equity indebtedness taken to fund a 529 plan is not deductible against the “alternative minimum tax.” Your cash-out amount may be classified as home-equity indebtedness.
- Your strategy may negatively impact your child’s eligibility for financial aid in the future. Home equity currently does not count against the student in the federal financial aid formula, but 529 plan assets do. A 529 plan account owned by the student or parent is treated as a parental asset, with no more than 5.64% of its value reducing eligibility for need-based financial aid.
Savings in a 529 plan will not keep pace with increases in college costs when the 529 plan is funded with debt, since the interest paid on the debt will reduce the net rate of return.
[Editor’s note: This article was originally published on May 12, 2003 and updated on October 20, 2020 by Mark Kantrowitz.]