Should You Use a Home Equity Loan to Pay for College?

Paying for college can be a major financial challenge, leading many families to explore borrowing options. One potential source of funding is home equity, which allows homeowners to borrow against their property’s value. This approach often offers lower interest rates than private student loans but comes with risks.

Before deciding to use home equity for education expenses, it’s important to weigh the benefits and drawbacks. Understanding how these loans work, their repayment terms, and their impact on financial security will help in making an informed choice.

Loan Eligibility Criteria

Lenders evaluate several factors before approving a home equity loan, with the most important being the amount of equity available. Equity is calculated by subtracting the remaining mortgage balance from the home’s market value. Most lenders require homeowners to retain at least 15% to 20% equity after borrowing, meaning the maximum loan-to-value (LTV) ratio typically falls between 80% and 85%.

For example, if a home is worth $400,000 and the outstanding mortgage is $250,000, the available equity is $150,000. However, if the lender enforces an 80% LTV cap, the maximum loan amount would be $70,000 rather than the full $150,000.

Creditworthiness also plays a role in eligibility. Lenders assess credit scores, debt-to-income (DTI) ratios, and payment history. A credit score of at least 620 is generally required, though scores above 700 qualify for better interest rates. The DTI ratio, which compares monthly debt payments to gross income, should ideally remain below 43%, though some lenders may allow higher ratios for borrowers with strong credit profiles.

Income stability is another key factor. Lenders require proof of consistent earnings, typically through recent pay stubs, tax returns, and W-2 forms. Self-employed individuals may need to provide two years of tax filings and profit-and-loss statements. A steady employment history of at least two years is often preferred.

Types of Home Equity Financing

Homeowners considering borrowing against their property for education expenses have multiple options, each with distinct features and risks.

Lump-Sum Equity Loan

A home equity loan provides a one-time lump sum, repaid in fixed monthly installments over a set term, typically ranging from five to 30 years. The interest rate is usually fixed, ensuring consistent payments. This predictability can help with budgeting for multi-year college expenses.

The loan amount is determined based on the home’s appraised value, outstanding mortgage balance, and lender-imposed LTV limits. Closing costs, typically ranging from 2% to 5% of the loan amount, may apply. Since the loan is secured by the home, failure to make payments could result in foreclosure.

This option is best for those who need a specific amount upfront and prefer a structured repayment plan. However, once the funds are disbursed, additional borrowing requires a new loan application.

Equity Line of Credit

A home equity line of credit (HELOC) functions as a revolving credit account, allowing homeowners to borrow as needed up to a predetermined limit. Unlike a lump-sum loan, a HELOC typically has a variable interest rate, meaning payments can fluctuate based on market conditions. The interest rate is often tied to the prime rate, plus a margin set by the lender.

HELOCs have two phases: the draw period, usually lasting 5 to 10 years, and the repayment period, which can extend up to 20 years. During the draw phase, borrowers can withdraw funds as needed and may only be required to make interest payments. Once the repayment phase begins, no further withdrawals are allowed, and principal payments become mandatory.

This option offers flexibility, making it useful for covering tuition payments over multiple years. However, the variable interest rate introduces uncertainty, and if rates rise significantly, repayment costs could increase. Some lenders also charge annual fees or require minimum withdrawals, which should be factored into the decision.

Refinance Option

Cash-out refinancing involves replacing an existing mortgage with a new, larger loan and receiving the difference in cash. This approach can provide substantial funds for education expenses while potentially securing a lower interest rate if market conditions are favorable. The new loan typically has a fixed or adjustable rate and a repayment term of 15 to 30 years.

One advantage of refinancing is consolidating debt into a single monthly payment, which may be lower than the combined payments of a mortgage and a separate home equity loan. However, closing costs, which can range from 2% to 6% of the loan amount, must be considered. Extending the mortgage term could also result in higher total interest payments over time.

This option is most beneficial for homeowners who can secure a lower interest rate or need a large sum for tuition. However, it resets the mortgage clock, meaning borrowers may take longer to build equity. If home values decline, there is also a risk of owing more than the property is worth.

Determining Loan Amount and Schedule

Estimating how much to borrow requires a careful assessment of tuition costs, living expenses, and the repayment structure that best aligns with household finances. Colleges provide a breakdown of tuition, fees, and room and board, but these figures don’t account for cost increases over time. Public universities often raise tuition annually, and private institutions can adjust fees. Factoring in an expected increase of 3% to 5% per year ensures the loan covers the full duration of enrollment.

The repayment schedule must also be structured to avoid financial strain. Fixed-term loans provide predictable monthly payments, but the length of the loan affects affordability. A 10-year repayment term results in higher monthly obligations but minimizes total interest paid, whereas a 20- or 30-year term reduces immediate costs but increases the total repayment amount. Using an amortization schedule can help project long-term costs and determine whether a shorter or longer loan term is more sustainable based on current income and expected career progression.

Interest rate fluctuations should be considered when choosing between a fixed or variable rate structure. Fixed rates lock in a consistent payment, which is advantageous if rates rise. Variable rates may start lower but can increase over time. Reviewing historical interest rate trends and economic forecasts can provide insight into whether a variable rate is a risk worth taking.

Tax Treatment of Home Equity Interest

The tax deductibility of home equity loan interest changed significantly with the Tax Cuts and Jobs Act (TCJA) of 2017. Previously, interest on home equity loans and HELOCs was generally deductible regardless of how the funds were used. Under the revised tax code, interest is only deductible if the borrowed funds are used to buy, build, or substantially improve the home securing the loan. This means that if home equity financing is used for college tuition, student housing, or related expenses, the interest is not deductible on federal income tax returns.

State-level tax treatment varies, with some states allowing deductions even when the proceeds are used for non-housing expenses. Taxpayers should review the specific rules in their state, as some jurisdictions, such as California and New York, have more favorable provisions regarding home equity interest deductions. Additionally, interest deductibility is subject to the overall mortgage debt limit, which caps deductible interest on combined mortgage and home equity debt at $750,000 for married couples filing jointly ($375,000 for single filers), though loans taken before December 16, 2017, may qualify under the previous $1 million limit.

Primary Collateral Considerations

Using home equity to finance education expenses means putting the property at risk, as the home serves as collateral for the loan. If financial difficulties arise and payments are missed, the lender has the right to initiate foreclosure proceedings. Unlike federal student loans, which offer deferment and income-driven repayment options, home equity loans have stricter repayment terms with fewer opportunities for relief in case of hardship.

Market conditions also play a role in the long-term implications of borrowing against home equity. If property values decline, homeowners may find themselves in a negative equity situation, where the outstanding loan balance exceeds the home’s market value. This can complicate future refinancing opportunities or the ability to sell the home without incurring a financial loss. Additionally, if interest rates rise, variable-rate HELOCs can become more expensive over time. Homeowners should carefully evaluate their ability to manage payments under different economic scenarios before committing to this financing option.