After looking at a financial aid award letter, families may find a large tuition gap that they have to fill. Sometimes, the award letter does this for them by including a Parent PLUS loan for mom and dad to cover the remaining costs.
Many parents will take on these loans to ensure their child can attend school. However, doing so can be expensive—and can affect their other financial goals, like saving for retirement. As a result, some parents look toward funding sources that might cost less than Parent PLUS loans, like home equity loans.
What Are Home Equity Loans?
Home equity loans allow homeowners to take out a line of credit against the value of their homes beyond what they owe on their mortgage. For example, let's say your home is worth $200,000 and you owe $150,000 on your mortgage. The "equity" you could borrow would be $50,000 ($200,000 – $150,000).
Why Families Choose Home Equity Loans
Home equity loans can be an inexpensive option for parents to pay for their child's college education. In 2015, the interest rates on these loans hover around 5%, which is lower than the current Parent PLUS loan rate of 6.84%. Add in the PLUS loan's 4.2% origination fee (which home equity loans rarely charge), and the home equity loan looks like a much cheaper option.
Consider this example: The average Parent PLUS loan borrower in the 2014-2015 academic year borrowed approximately $31,000 by their child's graduation. At 6.84%, they would pay $357 per month and $11,810 in interest over a standard 10-year repayment plan. With an origination fee of $1,302, that loan's total cost would be $44,112.
If that parent borrowed a home equity loan for the same amount with a 5% interest rate, their payments would decrease to $329 per month and they'd pay just $8,456 in interest. With no origination fee, the total cost would be $39,456—or $4,656 less than the Parent PLUS loan.
Also, home equity loans can be a more tax-efficient option. When filing federal tax returns, borrowers can deduct up to $100,000 in interest annually for these loans, but only $2,500 for Parent PLUS loans.
Home Equity Loan Risks
So, based on all that, choosing a home equity loan should be a no-brainer, right? Well, for many families in the early 2000s, it was. However, after housing values collapsed in 2007, the risks of using these loans to pay for school became quite apparent.
Your home is collateral: When you borrow a home equity loan, you essentially put your home up as collateral. That means that if you don't repay the loan, your lender can repossess your house; you essentially gamble your home to pay for school. That's a big bet!
The housing market is volatile: If you borrow against your home value and the housing market weakens, you could become "upside down" on the home, meaning you owe more than it is worth. This can make it hard to build more equity in your home or profit when you sell it.
These loans affect financial aid: The money a family receives from a home equity loan may count as income when the expected family contribution (EFC) is calculated on the Free Application for Federal Student Aid (FAFSA). Though the money is for a child's education, it's still considered income for the parents and will likely drive up the EFC, possibly hurting the child's eligibility for some need-based financial aid.
Parent PLUS Loan Benefits
Even if you feel comfortable with the risks of a home equity loan, Parent PLUS loans do typically have one big advantage: better repayment options. In general, federal student loans come with more generous repayment, postponement, and forgiveness options than private loans, including home equity loans.
Some home equity loans do let you make interest-only payments for up to 10 years. This may sound like a great option for those with tight budgets, but payments will be much higher after that 10 years—and parent borrowers may be near retirement at that point. Because of this, some may have to work longer than they had intended to pay off their debts before they retire.
Borrowers with Parent PLUS loans can consolidate them to use the income-contingent repayment (ICR) plan, which caps monthly payments at 20% of disposable income. After 25 years (10 if the borrower works for a public service or nonprofit employer), the remaining balance would be forgiven, but that amount would be taxable. Payments under this plan can be as low as $0.
Having a repayment option like this may allow parent borrowers (even those nearing retirement) to feel more comfortable when borrowing. After all, they can be confident that the payments will fit in their budget, and this may make Parent PLUS loans a safer option for families to finance higher education expenses.