As the cost of college continues to rise, many parents wonder how they can best help their children pay for a higher education. It's a good idea to explore all of your options when figuring out how to pay for college. Exhaust any free financial aid that is available to you, and then consider your loan options. Federal and private student loans are the most common types of loans used to pay for college, but there are other options, including 401(k) loans and home equity loans.
Even though using your own assets to fund college can be tempting, it's important to realize that there are important considerations when thinking about tapping into your retirement account or home equity to pay for some or all of your child's college education.
Interest Rates and Fees
One of the reasons people look to their 401(k) plans and home equity for loans is the low interest rate. Mortgage rates can be lower than some unsecured loans, but they can change daily so it's important to watch the rates closely to lock in a favorable rate. The interest you pay on your mortgage may be tax-deductible. With a 401(k) loan, you might be able to qualify for a favorable rate. Plus, the interest you pay on a 401(k) loan is paid back to you since you are borrowing from yourself.
You may have to pay origination fees with 401(k) loans and home equity loans.
Most 401(k) loans need to be repaid within five years. However, if you leave your job or are laid off, you might only have 60 days to repay the entire balance before you are charged taxes and penalties on the amount still outstanding. You also have to keep in mind that there will be a 10 percent withdrawal penalty for anyone younger than 59½, and federal income tax must still be paid on your savings.
Home equity loans can have repayment terms from 5 to 30 years, so there is more flexibility to repay depending on your circumstances. Keep in mind that unlike student loans, loans taken against your 401(k) or home equity don't come with in-school deferment or forbearance options should you lose your job or have difficulty making payments. You will be required to start repaying your debt immediately, leaving you with fewer alternatives later on.
Remember that your child has a longer period of time to pay off student debt. When you are close to retirement, you could be jeopardizing your future by taking on debt to pay for your child's college education.
With a 401(k) loan, there is an opportunity cost. While you are paying yourself back with interest for the money you borrow for school, there is no replacing lost time. As long as that capital is gone from your retirement account, your nest egg is growing at a slower rate and that could impact your retirement in the long term. Your child can get student loans and have plenty of time to repay them at a reasonable rate. There are no loans for retirement.
With a home equity loan, you are tying up one of your most valuable assets for a period of time. Once you secure your child's education with your home, however, you run the risk of losing it if you have difficulty making payments. A home equity loan can also set you back in terms of becoming debt-free and maintaining ownership in your home.
Before you decide how to pay for your child's college education, compare the options. We encourage you to consult a financial planner for detailed information about paying for college and creating the right strategy for your family.