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There are several tradeoffs that should be considered when deciding whether to use a home equity loan, a home equity line of credit (HELOC) or a cash-out refinance instead of borrowing a student or parent loan or to refinance a student or parent loan.
Despite the rhetoric about borrowers tapping into their home equity, these loans are really just substituting one form of debt for another.
One should consider the advantages and disadvantages of each option. Home equity loans, HELOCs and cash-out refinance may yield significant cost savings, but also involve greater risks if the borrower encounters financial difficulty.
Advantages of home equity loans and lines of credit
Home equity loans, HELOCs and cash-out refinance mortgages offer a few advantages over student loans and parent loans.
Lower interest rate. Home equity loans and HELOCs may offer lower interest rates than Federal PLUS loans and private student and parent loans because they are secured by the home. This reduces the risk to the lender if the borrower defaults. The lower interest rate may save the borrower thousands of dollars in interest over the life of the loan.
See also: Complete Guide to Parent Loans
Tax deduction. Borrowers previously were able to deduct the interest on up to $100,000 in home equity debt, without regard to income. This tax deduction required the borrower to itemize deductions and was subject to the Alternative Minimum Tax (AMT).
This is in contrast with the Student Loan Interest Deduction, which allows taxpayers to deduct up to $2,500 in interest paid on federal and private student loans as an above-the-line exclusion from income. The student loan interest deduction is subject to income phase-outs which were $65,000 to $80,000 for single filers and $135,000 to $165,000 for joint filers in 2017. (The income phase-outs are adjusted annually for inflation.)
However, the Tax Cuts and Jobs Act of 2017 (P.L. 115-97) suspended the home equity interest deduction for home equity debt for tax years 2018 through 2025, inclusive.
Interest-only payments. Some HELOCs provide an option of interest-only payments for 10 years, followed by fully amortized payments and principal and interest for five years. Although this provides a lower initial monthly payment, the monthly payments will increase a lot after 10 years.
Disadvantages of home equity loans and lines of credit
There are several disadvantages to home equity loans, HELOCs and cash-out refinance mortgages as compared with student loans and parent loans.
Consequences of default. If you default on a home equity loan, HELOC or cash-out refinance, you can lose the home. If you default on a student loan, the lender cannot repossess your education.
Fixed vs. variable interest rates. Interest rates on a home equity loan are usually fixed, while interest rates on a HELOC are usually variable. Federal loans have fixed interest rates, while private loans may offer both fixed and variable rate options. In a rising-rate environment, variable interest rates can lead to increases in the monthly loan payment.
Prepayment penalties. Home equity loans and HELOCs may have prepayment penalties. There are no prepayment penalties on federal and private student loans.
Impact on aid eligibility. The remaining loan proceeds from a home equity loan must be reported as an asset on the Free Application for Federal Student Aid (FAFSA). This can reduce the student’s eligibility for need-based financial aid.
Limited repayment options. Home equity loans and HELOCs are not eligible for deferments and forbearances, income-driven repayment, death and disability discharges or student loan forgiveness. Home equity loans and HELOCs must be repaid if you sell the home.
Closing costs. The closing costs on a home equity loan or HELOC may increase the cost of the loan.
