Mortgage Financing: Is It a Smart Way to Pay for College?

Thinking about college tuition?  Wondering about how to pay for that college degree?  You are not alone.  Many families turn to their home as one source to pay for college bills.  But is it the smartest thing to do?  A recent article in USA Today explored this question with the response from a fellow fee only personal financial planner.  (Is a Mortgage a Smart Way to Pay for College? April 19, 2013).

In the article a 50-year old couple faced with college for their kids in four years asked:

“My wife and I have no debt. We contribute to our 401k. But because our kids will be going to college in four years, should we take out a home mortgage now to lock in a low rate and deduct the interest payment? This way we will have some money to pay for college without borrowing from our 401(k) plans.”

These folks are in a very enviable spot: Positive cash flow, no mortgage, 401k plans funded. They even have home equity available to tap (it helps when you don’t have a mortgage).

Need a Plan, Not Just a Loan

Before the real estate bubble burst, folks often saw their homes as magic piggy banks – an unending source of equity to tap for all sorts of material wants and even college funding.  Not so much now.

But if you are in the position of having no mortgage or lots of equity now even after the bubble, should you use your home?

This couple has equity that can easily be used to pay for college.  So they don’t have a college funding problem.  Or do they?

On its face, it may seem that they are OK.  In reality, loading up on debt without looking at the broader personal financial picture can really hurt both their college financial aid prospects in the near-term as well as their personal bottom line in the longer-term.

Why?  Because home equity is not a factor for determining a family’s Expected Family Contribution (EFC) when a student applies to a school using the Federal Methodology.  And even for the relatively few schools that do use the Institutional Methodology, many of those schools place limits on how much home equity will be counted.  (So not tapping home equity is actually good for them from a financial aid perspective).

On the other hand, having a stash of cash presumably from the cash out refinance hinted at by this couple will be detrimental to their EFC and may cost them in the form of lost financial aid.

Sure, mortgage interest is tax deductible but that is only up to a point.  And it is only deductible if you actually itemize deductions (file your taxes with a Schedule A attached).  And then it only applies to that marginal portion that is above the standard deduction.

What About Retirement?

And what about this couple’s retirement?  Sure, tapping the home equity may help address the near-term cash flow issue of paying for college.  Selling the house and using the net proceeds also does the same thing – though you will be homeless in that case – which is certainly one way to avoid Boomerang Kids coming home to roost.

Let’s not confuse short-term and long-term.  You really should have an integrated approach that looks at balancing college funding needs with retirement or other family financial goals.

A better option is to use the run-up until college right now to fund retirement as much as possible.  So this couple could actually take advantage of “catch up” provisions to add more to their 401k.  This stash of money is not counted by either the Federal or Institutional Methodologies.  And you’ll need this money for retirement.  It may be cliche but it is true that you can borrow for college but you can’t really borrow for retirement.

Then this couple could look at tapping the home equity later in the form of either a conventional mortgage or a Home Equity Line of Credit.

Tapping the 401k?

Not a good idea.  In few circumstances would I ever suggest tapping the 401k.  This shouldn’t be considered a piggy bank.  And if ever separated from employment, this outstanding loan could be considered taxable income which would further hurt their odds of financial aid eligibility.

What About the Cash?

To minimize the impact of having large amounts of cash floating around after a refinance which would need to be reported as assessable assets, a couple could consider using the funds to fund a short-payout immediate fixed annuity – a term that corresponds to the college paying years or deferring until after college to use to pay off any accumulated debts.  Why?  For the most part, annuities are not considered as reportable assets.  And only a portion of any payout is considered income which can be offset elsewhere by doing other strategies in a plan.

Or they could use a HELOC only when needed during the college years.  Having a HELOC in place anyway is a low-cost smart way to have access to emergency reserves.

The bottom line is that like most families this couple could benefit from having a family funding plan in place instead of an ad hoc arrangement done on the fly when the tuition bills come due.