Some parents may be tempted to borrow against assets that they already have — such as equity in their home or their retirement account — to fund their children’s college education.
But before they do so, they should think carefully about the risks, says Jamie Malone, a principal and financial strategist in the Richmond, Virginia, office of financial planning firm JoycePayne Partners.
“I’ve had situations where parents want to put their children in a better situation, and they’re willing to make sacrifices above and beyond what they can really afford,” says Malone.
Home Equity Loans
Taking out a home equity line of credit or loan to pay for college may seem appealing: The interest rate is typically low and interest payments are tax deduct i ble up to $100,000 in debt. About 1 percent of families took out a home equity loan or HELOC to help pay for college, using an average of $6,517, according to the 2017 Sallie Mae study, “How America Pays for College.”
But know the pitfalls, says Ric Edelman, founder and executive chairman of Edelman Financial Services. “The downside for most middle class families is much worse than the benefits of the upside,” Edelman says.
[Weigh whether to use your home to pay for college.]
The biggest risk to this strategy is that you’re jeopardizing your home if your financial circumstances change — say, if you suffer a job loss or medical crisis — and you’re unable to make the loan payments.
“This is a loan on your home,” Malone says. “If you’re not able to make that home equity line payment, if you default, you could lose your home. That’s why I think it’s a real risk that you don’t want to take lightly.”
Families are also betting that the value of their house will continue to rise, Edelman says, which was a gamble that some parents lost when housing prices fell sharply in 2007.
“Parents and grandparents are setting themselves up for financial disaster because they’re counting on the equity in their home to be a major resource for themselves in their retirement,” says Edelman. “But if they spend that home equity on the child’s education, they’re destroying that essential part of their own financial plan.”
Borrowers should also beware that home equity lines of credit are typically adjustable rate. That means that even if they start low, “you’re dealing with something that’s an unknown in the future,” Malone says.
Retirement Accounts
It may also be possible to borrow against the value of the assets in a qualified retirement account, for instance, a 401(k) or 403(b). The benefit here is that there is no 10 percent early withdrawal penalty and your loan proceeds won’t be counted as income in financial aid calculations. The maximum loan amount is $50,000 or 50 percent of your vested account balance, whichever is less, according to the IRS.
“If a home mortgage loan is a bad idea, borrowing from your retirement plan is far worse,” says Edelman. “It’s the worst possible place to borrow money from.”
[Consider three college savings strategies for parents nearing retirement.]
The first danger is if you lose your job or take a different one: You may be required to pay back the loan immediately with interest.
“What if someone got laid off?” Malone says. “Are they required to repay that loan, and if so, would they be able to do that?”
Loan repayment must occur within five years, according to the IRS. If you’re unable to do so and you’re under age 55, the loan proceeds will be counted as a taxable distribution, and you’ll pay taxes plus a 10 percent penalty, Edelman says.
You’re also subject to double taxation. That’s because the money that you use to repay the loan has already been taxed — unlike money taken out of a paycheck for retirement — and will be taxed again when you pull it out at retirement.
“So every dollar you borrow in that way, you end up paying taxes twice,” says Edelman. “It’s horrific.”
Because the loan actually involves selling securities from your retirement account, bear in mind that when you repay it, the money will be used to repurchase the securities you sold earlier , Edelman says.
“It’s as if you took the money out five years ago and put the money back in today,” Edelman says. “You’ve missed the profits of the last five years. That’s a huge expense to the parent in terms of their retirement value.”
[Follow these 10 steps to minimize student loan debt.]
Consider a Cheaper College
If you’re turning to risky borrowing strategies to fund your child’s college education, experts suggest it may be time to re-evaluate the colleges you and your child are considering .
“From a financial standpoint, really, I think the goal here is to minimize the amount of debt that students and parents take on,” Malone says. “That is something you want to make sure you take into consideration.”
Trying to fund your education? Get tips and more in the U.S. News Paying for College center.
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Weigh the Risks of Borrowing From Yourself to Pay for College originally appeared on usnews.com
