Managing college costs can be extremely stressful. While the most obvious choice for college financing is a federal student loan, this may not always cover the full cost of tuition, housing and other related expenses. In these cases, you may be left wondering whether you should pay for college with a 401(k) or home equity loan.
While these alternative sources of funding can provide cash for school, there are also several serious downsides to consider. We created this comprehensive guide to help you understand whether taking out a 401(k) loan or home equity loan to pay for college is the right decision for you. Read on to learn about the advantages as well as the risks and drawbacks of each option.
Table of Contents
- Can you use a home equity loan to pay for college?
- The benefits of home equity loans for college financing
- The disadvantages of taking out a home equity loan for college
- Can I use 401(k) for college without penalty?
- The benefits of withdrawing from 401(k) for education
- The drawbacks of using your 401(k) for college
- Is using a 401(k) to pay for graduate school a good idea?
- Summary of Money’s should you pay for college with a 401(k) or home equity loan
Can you use a home equity loan to pay for college?
You can use a home equity loan to pay for college. Home equity loan lenders determine the amount you can borrow according to the amount of equity you have in your home. These loans are typically offered at a fixed interest rate, and you’ll receive the money as a lump sum with no restrictions on how you can use it.
The benefits of home equity loans for college financing
There are some key benefits of using a home equity loan for college. Most significantly, this financing option may offer lower interest rates than other types of financing. Home equity loans for college may also come in greater amounts than those accessible via federal student loan programs.
Potentially lower interest rates compared to private student loans
The best home equity loans typically carry lower interest rates than private student loans. Of course, average rates largely depend on the greater economic and interest rate environment at the time of borrowing.
Additionally, if you have plenty of home equity and strong creditworthiness factors, your home equity loan rate could be lower than what’s available through graduate-level federal student loans and Direct PLUS loans. These federal loans have higher interest rates than undergraduate-level federal student loans.
Potentially bigger loan amounts compared to federal student loans
Home equity loans usually have maximum loan amounts of 80% to 90% of your home’s current value minus any outstanding mortgages or liens. So, if you own a house worth $100,000 and owe $60,000 on your mortgage, you may be able to borrow as much as $30,000. That means you can potentially borrow more than the aggregate loan limits of federal student loans, which are set by Congress.
The current federal student loan limit for undergraduates is between $5,500 and $12,500 per year depending on whether the student is claimed as dependent on another person’s tax return.
Graduate/professional students can borrow up to $20,500 in direct unsubsidized loans each year. Direct PLUS loans, which are available to parents of dependent undergraduate students and graduate/professional students, have no fixed annual or aggregate limits. Instead, the maximum limit for this loan is the cost of attendance minus other financial aid received.
The disadvantages of taking out a home equity loan for college
There are also some serious risks associated with taking out a home equity loan for college costs.
Putting your home at risk as collateral
The main reason why home equity loans can come with lower interest rates and higher maximum loan limits is because the loan is secured by your home. If you fail to adhere to the loan terms and repay the loan as scheduled, your lender may be able to foreclose on your home to recoup its losses.
Long-term impact on home equity and financial stability
Taking out a home equity loan can also have a long-term impact on your home equity and financial stability. When you take out a home equity loan, the principal balance of that loan will be added to your existing mortgage debt. This significantly reduces the amount of equity you have in your home. It also reduces your financial flexibility, as it adds an additional loan with a long-term repayment schedule to your existing debt.
Can I use 401(k) for college without penalty?
If you decide to empty or withdraw funds from your 401(k) before reaching retirement age (59 ½ for traditional plans), you must pay a 10% early withdrawal penalty in addition to applicable taxes. There are some exceptions that can allow you to access funds without paying a penalty (e.g., medical bills or buying a first home).
You may qualify for a 401(k) hardship exception withdrawal education expenses if you’re a student or a parent/guardian of an enrolled college student. You must also prove that the higher education expenses are prohibitively expensive and will cause severe financial hardship.
Rather than taking the funds out of your 401(k) and paying a penalty, you can borrow against your 401(k). A 401(k) loan allows you to borrow from your plan funds without having to pay the 10% penalty tax — though you must pay back the loan to your 401(k) plan with interest. These loans can typically be taken out for up to $50,000 (or half of your vested balance)and come with repayment terms of five years.
With some employer plans, if you leave your job before repaying the loan, you must repay the balance before your next tax filing deadline. In addition, you may be subject to a 10% penalty if you fail to adhere to the loan terms.
The benefits of withdrawing from 401(k) for education
Just like when you get a home equity loan, there are some benefits to taking out a 401(k) loan or making an early withdrawal from 401(k) for education purposes.
Potential tax benefits and withdrawal options
Depending on the type of 401(k) plan you have, educational expenses may qualify for either penalty-free withdrawals or favorable tax treatment. Some 401(k) plans allow for hardship withdrawals or loans taken out specifically to pay for qualified educational expenses.
Retaining control over retirement savings
If you decide to take out a 401(k) loan or make a withdrawal, you’ll be able to retain control over your retirement savings. Because the funds are taken from your own retirement account, you’re borrowing from yourself — not a lender or other external source. This will also help you to avoid paying interest to an outside lender like you would when borrowing from a financial institution or another external source.
The drawbacks of using your 401(k) for college
Drawbacks from using your 401(k) for college include the possibility of draining your retirement savings and various potential withdrawal penalties, fees and taxes.
Impact on long-term retirement savings
If you decide to take early withdrawals from your 401(k), you may sacrifice long-term retirement savings and security by taking out money that would otherwise be growing in a tax-deferred retirement account. Similarly, a 401(k) loan will result in lower growth of your retirement account, as your money can’t stay invested if you’re borrowing it to pay for college.
Additionally, some 401(k) plans won’t allow you to make additional contributions until the loan is repaid, which could seriously set back your long-term retirement savings goals.
Potential penalties, fees and taxes
Early withdrawals made from traditional 401(k) plans before the age of 59 ½ will likely incur an IRS early withdrawal penalty of 10%. You’ll also have to pay state and federal income taxes on the early withdrawal amount. Similarly, you’ll be double taxed on a loan from your 401(k) because you’ll repay the loan with after-tax money and then be taxed on those funds again when you withdraw them in retirement.
Is using a 401(k) to pay for graduate school a good idea?
Whether using a 401(k) to pay for graduate school is a good idea depends on your individual circumstances. On one hand, tapping into your retirement savings for graduate school expenses can help you cover those costs without taking out additional student loans or going into debt. However, the potential penalties, fees and taxes associated with early withdrawals from a 401(k) could mean paying more in the long run.
The risks associated with a 401(k) loan may be lower than taking early withdrawals but can still impact your long-term retirement savings. Ultimately, dipping into your 401(k) for graduate school should be viewed as a last resort. It might make sense in some unique situations where a graduate degree will significantly increase your earning power and you want to avoid traditional loans.
Summary of Money’s should you pay for college with a 401(k) or home equity loan
Taking money out of your 401(k) or using a home equity loan to pay for college tuition and other college expenses can be risky. Home equity loans put you at risk of losing your home, while tapping into your 401(k) may result in penalties, fees and the risk of double taxation on retirement funds.
Although there are some limited situations where either of these options may make sense, only consider them after looking into all other financial aid and loan options.