Monday, April 15, 2013
Is a mortgage a smart way to pay for college?
Story originally appeared on USA Today.
Money Watch, a personal finance column that runs every Saturday, features a financial planner from the National Association of Personal Financial Advisors answering reader questions about saving, protecting and growing your money.
Q: My wife and I have no debt. Our home, cars and credit cards are paid off. We make the maximum contributions into our 401(k) plans, although we don't take advantage of catch-up contributions. But because our kids will be going to college in four years, should we take out a home mortgage now to lock in a low rate and deduct the interest payment? This way we will have some money to pay for college without borrowing from our 401(k) plans.
A: Congratulations on being debt free! That is a huge accomplishment, and one that you should be proud of.
I agree that you need to find a way to help pay for your kids' college expenses without tapping your 401(k) plans. Even if you have the best intentions, if you are ever laid off or quit you will have to pay back the 401(k) loan immediately or face stiff taxes and penalties. And it may not be the best time to have to pay back a loan, having just lost your salary.
MONEY WATCH: Pay down mortgage or save for kids' college?
I am not sure taking out a home loan to pay for your kids college education is the best decision, either. You would be putting your home at risk, which isn't a good idea. And never let the tax benefits influence your financial decision. You can only deduct the interest on your mortgage if you are itemizing your deductions, and even then you would only benefit from the amount of deductions that are greater than the standard deduction ($11,900 for 2013). This means if you take out a mortgage and then have $13,000 of itemized deductions, you really only benefit from a $1,100 deduction. Multiply this deduction by your tax rate to get the actual tax benefit, and you will find that it really isn't all that much.
If you decide that using a mortgage is the way to go, one option would be to take out a home equity loan. The interest is still deductible, the upfront costs are typically lower, however the interest rate will probably be higher so you will need to ask your mortgage lender about your options.
I would start by determining your financial goals. When do you want to retire? How much money do you want to have for living expenses each year? Be sure you take into account health care expenses, car replacement, travel and any other financial goals you have. Determine how much you need to save each year in order to accomplish those goals.
Next, see what is left over. Although it can be difficult, you must put your own financial goals first. Your child can always take a year off from school to save money, or use student loans to pay for college, but there are no loans for retirement. If you don't save enough, you will put your kids in the position of having to support you later in life. I bet they would rather pay for their own education than have to pay for your retirement!
If you need to reduce the amount you are saving for retirement, be sure you at least take full advantage of your employer match.
If after you fully fund your own goals you find that you have some money left over each month, you can use a 529 plan to save for your kids' college expenses. Some states provide an income tax deduction to contribute to a 529 plan; however, there is no federal deduction for contributions. Check with your state-sponsored 529 plan to find out if there is a deduction available. The money in the 529 plan will grow tax-free, and can then be taken out without taxes to fund college expenses. You can even continue to contribute while your child is in college in order to get the tax deduction and some tax-free growth.
Finally, sit down with your kids today and let them know what they can expect in the way of college funding from you. They may have to take their second choice college, or put in the extra hours so they get a scholarship, but either way, they will be OK! Involve them in the discussion so there are no surprises. This will also be a perfect opportunity to teach them the value of planning for their personal finances.