We research, you save.

Student Loans vs Home Equity Loans

HSH.com

What's the best way to fund ever-rising cost of college? Is home equity financing a better deal than student loans? And what about the credit crunch -- are student loans even an option these days?

Paying for College: First, the Freebies

Your first stop in paying for college should be completing the Free Application for Federal Student Aid (FAFSA). This one form serves as your application for most types of need-based assistance: federal, state and college-sponsored financial aid, including grants, student loans and work-study programs. Grants will help to reduce your college costs.

Next: Federal Student Loans

Students should take advantage of as much federal student aid as you can qualify for. The most advantageous student loans are subsidized by the federal government and are available to those who demonstrate the greatest financial need. Federal Perkins loans carry an interest rate of 5%, and the government covers the interest payments while the student is in school, and for nine months after graduation. Subsidized Stafford loan rates are 5.6% for the 2009 - 2010 academic year, and are scheduled to decrease over the next several years. Next come unsubsidized Stafford loans, currently carrying a 6.8% interest rate, and then there are PLUS loans at 8.5%.

Private Student Loans

Private student loans are available for those whose college expenses exceed federal student loan limits. However, expect to pay a lot more -- interest rates on private student loans commonly exceed 15%. In addition, the credit crunch has made these loans difficult to get, so applicants need exceptionally-good credit to get them.

Funding Education with Home Equity Loans

If you're considering funding your child's education through a home equity loan, the interest rate on a home equity loan is clearly a better deal than the 15% interest rate charged to private student loans. Furthermore, a home equity loan -- otherwise known as a second mortgage -- may also be a better solution than some of the federal student loan programs as well. If you can deduct your mortgage interest at tax time, your effective interest rate on a home equity loan could be less than that of a PLUS or even a Stafford loan.

Fixed Home Equity Loan or Line of Credit?

For flexibility, a home equity line of credit (HELOC) can't be beat. You can tap into it as needed to pay for tuition as well as other expenses, and only pay interest on the amounts advanced. However, there are a couple of caveats: first, mortgage lenders can shut down credit lines if home values drop -- bye bye, tuition. Second, HELOCs come with variable interest rates, meaning 10 years from now, that education could prove very expensive if rates increase. That said, a fixed-rate second mortgage delivers the entire amount in one lump sum, and you must begin paying it off right away. Your lump sum can't be cut, and your payment is attached to a fixed rate. One way of splitting the difference is to get a HELOC that allows you to fix the rate at one or more points during the life of the loan.

Drawbacks of Home Equity Financing

Yes, home equity interest rates can be favorable, and the tax treatments can be tempting. But many experts believe that putting your home at risk to fund a child's education, while generous, is not the wisest choice for your financial health. In addition, many student loans offer benefits that home equity loans don't. For example, students who graduate with teaching or medical training may be able to have their student loans forgiven if they work in certain areas. Student loans can also be deferred in times of financial difficulty. Finally, paying for college for 20 or 30 years (via home equity) -- even with a low mortgage rate -- could increase your overall interest expense to the point where it far exceeds what you would pay over 10 years on a student loan with a higher rate.

A Place for Home Equity Financing

Home equity financing can be a valuable part of your college funding strategy. Just be sure that you aren't putting your home at risk, that you are fully funding your retirement and that you first take advantage of all cheaper sources of college funding.

Gina Pogol has been writing about mortgage and finance since 1994. In addition to a decade in mortgage lending, she has worked as a business credit systems consultant for Experian and as an accountant for Deloitte.

More help from HSH.com