Home equity can finance college

The motto for the University of California is Fiat lux, Latin for "Let there be light."

A lovely sentiment, but most parents of college-bound students have another, more practical wish: Fiat pecunia, or "Let there be cash."

The average cost of college tuition, room and board now hovers around $22,000 a year, according to the College Board. Even state schools average $10,000 a year, while the annual price tag for an Ivy League school can easily top $30,000.

There are, of course, numerous sources of financial aid for college-bound students. But many upper-middle-class parents find themselves in a gray zone: too wealthy to qualify for financial aid but not flush enough to bankroll four years of college. Baby boomers who haven't saved enough money for college are sometimes forced to dip into their retirement savings or borrow from their 401(k) plans.

Fortunately, there are other sources of cash for college that won't jeopardize your golden years. One is as close as your front door: a home-equity line of credit.

Homeowners have long used home-equity loans and lines of credit to pay for a new roof or bigger kitchen. But depending on your circumstances, a home-equity line of credit could also help you pay for college. Some advantages:

Lower rates. Home-equity loans and lines of credit are secured loans because your house is collateral for the loan. For that reason, the interest rate on a home-equity loan may be lower than rates for an unsecured student loan.
Home-equity rates are typically tied to the prime rate, which is the interest rate banks charge their best corporate customers. Now, lenders are offering home-equity lines of credit for less than 1 percentage point above the prime rate. The prime currently stands at 7.75%. The average rate on a home-equity line of credit is 8.68%, according to HSH Associates, a mortgage consulting firm.

In addition to traditional lenders, some colleges offer their own home-equity loan programs, often at competitive rates, says Kalman Chany, author of Paying for College Without Going Broke.

Less equity, more aid. Most state schools exclude the value of your home when calculating your eligibility for financial aid. But many private college financial aid offices count equity in your home as an asset in determining your net worth. When you borrow against your home, you reduce your equity, improving your chances for private-school aid.
More flexibility. With a home-equity loan, you typically get a specific amount of money, usually at a fixed interest rate. A home-equity line of credit works more like a credit card: You can borrow money when you need it, up to a set limit. That makes it a convenient way to pay . If your child wins a scholarship after the first semester, you can leave the loan alone.
Lower taxes. Unlike most other types of loans, home-equity loans and lines of credit are usually tax-deductible.
Peggy Ruhlin, a financial planner in Columbus, Ohio, says some of her clients are using home-equity loans for college costs even though they have enough in their investment portfolios to cover tuition. That way, she says, they can continue to earn money on their stocks and mutual funds. And by holding on to their investments instead of selling them, they avoid paying capital gains taxes.

When not to borrow

Don't even think of borrowing against your house until you've explored other sources of financial aid. If your child qualifies for a Stafford or Perkins loan, take advantage of those federally subsidized programs first, Chany says. Interest on Stafford and Perkins loans is deferred until your child finishes college, making them much more attractive than home-equity lines of credit, he says.

In addition, talk to your child's school about its student loan programs. Some student loans are available at more attractive interest rates than home-equity loans, Chany says.

If those alternatives prove unsatisfying, be aware of the pitfalls of a home-equity line of credit:

Like a credit card with a big limit, a home-equity line can tempt you to borrow more than you can afford to repay. If that happens, you could lose your home.
The interest rate on your home-equity line of credit could rise.
Because the rates are tied to the prime, an increase in that benchmark will boost the cost of the loan. Many economists think the Federal Reserve will raise rates later this year, which could cause banks to raise the prime.

If you're worried about rising rates, Ruhlin suggests another alternative: Refinance your home, take some cash out and use the money to pay for college.

There are a couple of advantages to this strategy, she says. Mortgage rates are lower than home-equity lines of credit, so you'll pay less for the money you borrow. If you refinance with a fixed-rate mortgage, you won't be affected by rising interest rates. And if you later find you won't need all the money, you can refinance again, pay down part of the mortgage and reduce your monthly payment.