I'm refinancing my mortgage. Is it wise to take out some extra cash to cover future college costs?
You're right about one thing: With the interest rate on a 30-year fixed-rate mortgage currently averaging just 5.51%, according to Bankrate.com, now is an excellent time to refinance. (Rates have inched up a bit over the past couple of weeks, but they remain near historical lows.) Tapping the equity in your home to cover future expenses, however, is a more complex issue.
Borrowing more money than the outstanding balance on the original mortgage is called a "cash-out refi." The way it works is that the lender allows the homeowner to borrow against the equity of the home's newly appraised value (usually up to 85%), which is then distributed as a lump-sum payment at closing. Homeowners have the lifetime of the mortgage to pay back the extra cash. One potential drawback of this strategy is that should the homeowner decide to sell relatively soon after the refi, there'd be less equity in the home, meaning less profit. That said, thanks to soaring home values and the currently low interest-rate environment, this maneuver can make a lot of sense for those paying off one-time expenses such as credit-card debt or medical bills, says Keith Gumbinger, vice president of HSH Associates, a mortgage tracking firm.
But college expenses that are two years or more away don't exactly fit that bill. Sure, interest rates are low these days, but that doesn't mean it's wise to borrow now for future costs. After all, why pay interest on money you aren't even using? The only way to justify this move would be if you could invest the money and earn more than the cost of borrowing on an after-tax basis, explains Stephen Barnes, a certified financial planner based in Phoenix. Given that the average money market currently yields 1.44% and a two-year CD offers a yield of 2.11%, that's a tall order.
Fact is, even if those college expenses were a bit nearer, many experts still wouldn't recommend parents tap the equity of their home — that is, unless they're fully confident that they have enough set aside for their own retirement. After all, what's the point of leveraging your home to foot education expenses if it just means that, come retirement, your kids will have to support you? Not to mention, these days — when most investments have taken a big hit — a home's equity can also provide a much-needed safety net should an emergency arise.
That said, for parents who are determined to tap their home's equity to pay for college, a more attractive option would be to set up a home-equity line of credit (Heloc), which allows homeowners to draw money against the equity in a home on an as needed basis. The advantage here is that the borrower only needs to pay interest on the money that's being used at any given time. The only drawback is that these rates move in conjunction with the prime rate. So when the Fed raises rates, the rate on a Heloc will move upwards also. Of course, right now the rate on a $30,000 Heloc is a mere 3.78% (and that's before the tax break), according to Bankrate.com. So unless the economy suddenly rockets forward (an unlikely scenario), it will most likely be a while before the rates on these loans become prohibitively expensive.
If you ask us, however, cash-strapped parents whose kids are still a few years away from college are better off investing the money they'll save each month on their refi in a 529 plan or Coverdell account. What that doesn't eventually cover can then be supplemented with financial aid, including Pell Grants and Stafford Loans. These days the interest rates on most student loans are quite low: For the 2002-03 year, federal-loan rates were a mere 4.06%. Privately funded loans such as Sallie Mae's Signature Loan are pegged at the prime rate. (For more on financial aid, read our college-planning section.)
Feeling guilty? Don't. Parent's who have some extra cash on hand when their kids graduate from college can always offer to help pay off those loans then. If not, the young graduate will have the next 30 years to pay the tab (provided he consolidates his loans after graduation).
Originally published on April 17, 2003.