If you own your home, then you may be wondering if the equity in your home can (or should) be leveraged to pay for college. You may also be wondering how the equity in your home affects your eligibility to receive federal, state, and institutional financial aid. Here we will explore the different types of home equity loans and how they can impact financial aid.
What is Home Equity?
First, let’s start with the basics. Home equity is the difference between the fair market value of your home and the value of any debts (mortgages) held against the home. Home equity accrues with every mortgage payment that you make and as real estate market values rise. Macroeconomic shifts in the market can cause significant fluctuations in the value of the equity in your home. A market contraction can result in you owing more on your home than it is currently worth (this is called being upside-down on your mortgage). Therefore, making mortgage payments does not guarantee, on a net basis, that your home will maintain its equity value.
Home Equity Loans
A home equity loan is basically a second mortgage on your house. Home equity loans are subordinate to primary mortgages, and therefore may carry slightly higher interest rates. (The higher rates compensate for the loan’s junior status to the primary mortgage in the event of bankruptcy). As a home equity loan is a second home loan, it adds another housing payment to your monthly expenses, in addition to your primary mortgage payment, which remains unchanged. Interest rates on home equity loans can vary widely, between five and ten percent or more, depending on your credit score, whether you have a primary mortgage, and the repayment term for the loan. Most home equity loans have repayment terms of 15 years or less, though some lenders will allow repayment terms of up to 30 years. Like any basic installment loan, the interest rate and monthly payments for home equity loans are fixed. Repayment is required to begin immediately after the loan is disbursed.
Home Equity Lines of Credit
A home equity line of credit (HELOC) is like a home equity loan that is not disbursed as a single lump sum. HELOCs allow borrowers to access home equity on an as-needed basis up to a certain maximum limit, while only paying interest on the amount actually drawn. Borrowers can typically draw on the line of credit for a specified length of time, usually five to ten years, before they must begin repaying the principal debt. However, interest begins to accrue from the date of the first disbursement, and must be paid monthly so long as any portion of the credit line is outstanding. Unlike with home equity loans, HELOC interest rates are typically variable, which means that they fluctuate with changes in banks’ prime lending rates. Introductory rates typically range from three to six percent; however, the interest rates assessed throughout the life of the loan can vary widely with market conditions. Many borrowers choose to convert HELOCs, either in part or in full, to fixed-rate loans once they begin to make principal repayments. HELOCs typically carry lower (or zero) upfront fees compared with home equity loans but have higher overall interest rates. HELOCs also usually have no application fee.
Home Equity Cash-Out Refinance Loans
A third option for home owners is a home equity cash-out refinance loan. A cash-out refinance loan increases the value of a homeowner’s current mortgage by refinancing the existing mortgage into a new, larger one, and pays out the difference to the homeowner in cash. Although the homeowner assumes a new mortgage, still only one monthly payment is required, since the original mortgage is eliminated. Interest rates for home equity cash-out refinance loans can be fixed or variable, and are typically lower than the interest rates for traditional home equity loans and home equity lines of credit. This is because home equity cash-out refinance loans are not subordinate to any other mortgages, and principal repayment must begin immediately, unlike with home equity lines of credit. Repayment terms can extend up to 30 years. However, since borrowers must refinance an existing mortgage, the upfront fees and closing costs tend to be higher than for other types of home equity credit.
How Home Equity Loans Affect Financial Aid Eligibility
Depending on whether you are completing the FAFSA or the CSS Profile, home equity loans will have differing levels of impact on your eligibility to receive financial aid. In addition, the different types of home equity loans can be considered differently, depending on the disbursement of loan proceeds.
Completing the FAFSA
The FAFSA requires information pertaining to your cash accounts, such as savings or checking accounts, although it does not directly consider the asset value of your family’s principal home. As such, the value of any unspent proceeds from home equity loans or drawn lines of credit will be considered for the calculation of your Expected Family Contribution (unless your family’s income falls below the minimum income threshold of $50,000, in which case your assets are not considered). Therefore, if you obtain a home equity loan or draw from a line of credit, causing the value of your cash accounts to rise, before submitting the FAFSA, then your Expected Family Contribution will increase. Make to sure to submit your FAFSA first, and then pursue your options for home equity loans or lines of credit. Borrow or draw only what you need, such that you do not have significant excess cash remaining in any bank accounts next year when it is time to submit a FAFSA again.
Completing the CSS Profile
Unlike the FAFSA, the CSS Profile does consider the equity value in your family’s home, in addition to the value of your cash accounts, when determining your Expected Family Contribution. While every school that uses the CSS Profile takes a slightly different approach, many schools link home equity to income by capping the amount of home equity that is considered for the EFC calculation based on an applicant’s income. (For example, a school may limit the assessment of a family’s home equity to no more than two times the family’s income. A family with an income of $75,000 would have its home equity appraised at no more than $150,000, regardless of the true market value of the home. Learn more about this here.) However, no such cap is applied to cash account balances, so the same advice for completing the FAFSA applies to the CSS Profile: Submit your CSS Profile before obtaining any home equity loan or drawing down a line of credit. The equity in your home will still raise your Expected Family Contribution, but probably less so than a large cash balance in bank or brokerage account. To the extent possible, your cash account balances should be minimized at the time that you submit your CSS Profile, in order to lower your Expected Family Contribution.
Utilizing Home Equity to Pay for School
After you have submitted your FAFSA and/or CSS Profile, you may want to seriously consider leveraging the equity in your home to help pay for school. You may be able to borrow up to 90 percent of your home’s current value, but to be eligible for a home equity loan or line of credit, most lenders require that your total outstanding mortgage debt not exceed 80–85 percent of your home’s current value. If you are seeking to obtain a very large home equity loan or line of credit, then many lenders have even stricter requirements.
In general, applying for a home equity loan or line of credit is much like obtaining a mortgage. In addition to filling out an application, you will need to submit financial documents, have your house appraised, and pass a credit check. In addition to a healthy credit score and credit history, lenders require proof of employment and verifiable source(s) of income. Not everyone is approved for a home equity loan or line of credit, and some may receive approval but on unfavorable terms.
Assuming you meet the requirements for a home equity loan or line of credit, there are both advantages and disadvantages to using this form of credit to pay for school.
The advantages of using a home equity loan or line of credit to finance a college education include:
- High borrowing limits: Depending on your lender, you may be able to borrow up to 90 percent of the value of your home. If you live in an area with high real estate values, or have paid a substantial amount of equity into your home, then your maximum borrowing limit could be quite high.
- Competitive interest rates: Since the loan or line of credit is secured by an underlying hard asset (your home), lenders are typically willing to offer more competitive interest rates than they would for a comparable unsecured form of debt (such as a private student loan).
- Available year-round: Unlike with most student loans (except for private loans), home equity loans and lines of credit are available at any time of the year. Applicants are not bound to annual deadlines such as are imposed by the FAFSA and CSS Profile. If you need extra cash mid-year to cover school expenses, then a modest home equity loan or line of credit is a very viable alternative.
- Plenty of options: If you are in a position to leverage the equity in your home to pay for school, then you have numerous creditors potentially interested in lending to you and several options for how the loan or line of credit is structured.
- Lines of credit can be particularly attractive, because they can have no impact on your eligibility to receive financial aid, depending on how much of the credit line is drawn. HELOCs can also be slightly easier to obtain and feature more generous repayment terms, although their interest rates are variable and typically higher.
- Traditional home equity loans and cash-out refinance loans enable borrowers to obtain large lump sums in single disbursements, and depending on the repayment terms, can feature very low financing costs.
- Cash-out refinance loans allow borrowers to replace existing mortgages with new, larger mortgages, thereby allowing the borrowers to continue making only single monthly mortgage payments.
Leveraging the equity in your home to pay for school also has disadvantages. Your home is a real, tangible asset, while an education is not, so you are effectively betting a hard asset to pay for a soft one. If you are in any way unsure of your ability to make payments on a home equity loan or line of credit, then you should only borrow a small amount relative to the value of your home, or you should not borrow against your home at all. In addition, consider these other relevant factors:
- Limited home equity available: Unless you have been paying down the mortgage on your home for many years already, you may not have very much equity in your home to tap. If you do not have substantial equity ownership in your home, then you may not be approved by lenders or may receive approval on unfavorable terms.
- Fluctuations in market value: Market contractions can severely reduce the appraised value of a home, which can significantly lower (if not negate) the home’s equity value. As such, the value of a home’s equity is subject in part to market forces. Shifts in the market can also greatly increase the financing costs of loans or lines of credit with variable interest rates.
- Lack of federal protections: Home equity loans and lines of credit offer none of the protections provided to borrowers by the U.S. Department of Education for federal student loans. In times of financial duress, federal loan borrowers can benefit from income-based repayment programs, loan forgiveness programs, and financial hardship provisions such as deferment and forbearance.
- Lack of flexible payment options: Home equity loans and lines of credit also offer none of the flexible repayment options provided to federal loan borrowers. Such options include loan consolidation and various programs that allow for flexible interest rates and repayment terms.
- Higher upfront fees: To successfully obtain a home equity loan or line of credit, you will likely need to pay application fees, attorney fees, appraisal fees, and closing costs. While other forms of student financial assistance also carry some upfront fees, the initial costs associated with home equity loans tend to be somewhat higher.
- Loss of eligibility for tax deductions: As a result of the U.S. Congress passing the Tax Cuts and Jobs Act in 2017, interest paid on home equity loans or lines of credit is now only tax-deductible if the loan or credit line proceeds are used to buy, build, or substantially improve the underlying asset (your home). In addition, interest paid on a home equity loan or line of credit is not eligible for the Student Loan Interest Deduction, even if you used the loan or credit line monies to pay for school.
Home equity loans and lines of credit, especially if obtained in moderation and in combination with federal loans and other forms of financial support, constitute very viable alternatives for financing a college education. Prospective borrowers should consider all their options before determining the best course of action.