If you own a home and have equity in it, you might consider taking out a home equity loan as a source of funds for your child’s college expenses. Alternatively, you might decide to refinance your mortgage to one with a lower interest rate or a longer term in order to create more discretionary income each month that can be used for education purposes. To qualify for a home equity loan or mortgage refinancing, you usually need a good credit history.

Mortgage refinancing

Mortgage refinancing refers to the process of taking out a new home mortgage and using some or all of the proceeds to pay off an existing mortgage. The main purpose of refinancing is to save money by taking advantage of lower interest rates or to lower monthly payments by extending the term of the loan. By doing so, you free up money that can immediately be used for education expenses.

There are actually two types of refinancing: a no-cash-out refinancing and a cash-out refinancing. A no-cash-out refinancing is when the amount of the new loan doesn’t exceed the mortgage debt you currently owe, plus points and closing costs. You can generally borrow up to 95 percent of your home’s appraised value with this type of refinancing.

A cash-out refinancing is when you borrow more than you owe on your current mortgage. You can then use the excess proceeds however you wish. Many people use this type of refinancing to pay off other outstanding loans. However, you are generally limited to borrowing no more than 75 to 80 percent of your home’s appraised value with this type of refinancing.

Keep in mind that closing costs are charged when you refinance your mortgage (points, application fees, filing fees), but lenders may eliminate these costs in an effort to gain your business. And, of course, your home serves as collateral for the new mortgage, just as with your original mortgage.

Home equity financing

Home equity financing uses the equity in your home to secure a loan. It is structured as either a home equity loan or a line of credit.

With a line of credit, the lender establishes a credit limit, which depends on the equity in your home and your ability to make payments. You can then access as much money as you need (up to the limit), whenever you need it, by writing a check or using your credit card. Generally, interest rates are variable and tied to an index. Your monthly payments will also vary, depending on your outstanding balance.

With a home equity loan (often referred to as a second mortgage), you borrow a fixed amount (typically no more than 80 percent of the equity in your home), which is transferred to you in full at the time of the closing. You must then repay that amount over a fixed term. If you repay the loan, the lender discharges your mortgage. If you do not repay the loan, the lender can foreclose on your home to satisfy the debt.

Home equity financing generally means a more favorable interest rate compared to an unsecured, personal loan, because your home secures the loan.

The major disadvantage of home equity financing is that your home is at risk because it serves as collateral for the loan. As such, the lender can foreclose on your home if you fail to repay the loan.

How do you know if this strategy is right for you?

If you need to borrow funds for college, a home equity loan might be appropriate. Compare the interest rate you can get on a home equity loan or line of credit with the cost to borrow elsewhere. If you think there is any chance you will have difficulty paying the loan back in the future, you should think twice. A home equity loan or line of credit is secured by your house, and the lender can foreclose on it if you default.

The decision whether to refinance your mortgage is usually dependent on current mortgage rates. If the current rate is more favorable than the rate of your current mortgage, the decision to refinance will likely hinge on whether you expect to stay in your current home long enough to recoup the costs of refinancing. You might also choose to refinance to a mortgage with a longer term in order to lower your monthly mortgage payment. For example, you now have a 15-year mortgage but will refinance to a 30-year mortgage.

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