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Banks often recommend a home equity loan or line of credit as an alternative to education loans. They argue that the interest rates are competitive with education loans and the interest is usually fully deductible. However, there are several aspects of these loans that should be considered.

Do not be misled by brochures that talk about "tapping the equity in your home". These brochures suggest that you are merely spending some of the equity you have saved in your home. The reality, however, is that a home equity loan or line of credit is a loan, not a savings account. The only connection with your home is the loan is guaranteed by the equity in your home, making it a lower risk loan for the banks. But the bottom line is that it is a loan and needs to be evaluated like any other loan.

The primary method of evaluating a loan is by comparing the interest rate on the loan with the interest rates on other forms of financing. The interest rates on most home equity loans and lines of credit are higher than the interest rates on the Federal Stafford and Federal PLUS loans, but lower than most private education loans. This means a Federal loan will cost less than a home equity loan, and a home equity loan will cost less than a private education loan.

So if you are thinking about getting a private education loan, you should consider a home equity loan or line of credit as a possible alternative. But generally you will be better off relying on the Federal education loans.

Mortgage lenders may argue that interest paid on a home equity loan or line of credit is usually fully deductible on your income tax return, while the amount of the deduction for interest from education loans is limited to $2,500. However, this limit corresponds to a debt of $50,000 at 5% interest, which is often enough for most parents. Even if this amount is insufficient, one should still borrow using the cheaper instrument until the limit of the benefit is reached.

Moreover, the deductibility of interest is effectively just a discount on the interest rate. When comparing loans, you should compare the net interest rates. If you are in the 25% tax bracket, the interest deduction is the equivalent of reducing a 5% interest rate to a 3.75% interest rate (5% - 25% * 5% = 3.75%). When you compare the net interest rates, you will find that the home equity loans are still more expensive than the Federal education loans. (Note also that the benefit of the mortgage interest deduction is limited by comparison with the standard deduction. You only benefit to the extent that your itemized deductions exceed the standard deduction. Also, the mortgage interest deduction is subject to the AMT and so may be subject to limitations, especially when used for expenses that are unrelated to the home, such as college tuition.)

Another consideration is the fees you may pay for a loan. Federal education loans and private education loans have fees, in addition to the interest rate. Home equity loans may also have fees. The fees on private education loans are usually higher than the fees on home equity loans, which in turn are higher than the fees on Federal education loans. Fees are simply another form of interest, and so such loans can be compared by calculating the equivalent interest rate with no fees. However, if you plan on paying off the loan before the end of the term, you will want a loan with lower fees, all else being equal, since fees are a form of interest paid up front.

An important difference is the impact of the loan on eligibility for need-based financial aid. A home equity loan will have a negative impact on financial aid, since any leftover proceeds from a home equity loan will be considered by the need analysis formula. This problem does not occur with a home equity line of credit, since you only draw down the line of credit when you need it to pay bills. Until you do so, the equity remains in the home, and net home equity is ignored by the Federal need analysis methodology.

Depending on whether the interest rate is variable or fixed, changes in interest rates will affect the amount of the monthly loan payments. If the interest rate is variable, your payments will increase when the interest rates increase. A fixed interest rate does not have this problem. A home equity loan typically has a fixed interest rate, while a home equity line of credit typically has a variable interest rate. (New Federal Stafford and Federal PLUS loans for which the first disbursement occurs after July 1, 2006 are at fixed rates of 6.8% and 8.5%, respectively.)

Refinancing your primary mortgage into an interest-only loan with automatic conversion back into a conventional fixed-rate mortgage after five years is not a good idea. Although this frees up the money you would otherwise be paying toward principal to help with college bills, the interest rate will relock upon conversion back to a fixed-rate mortgage. If interest rates are increasing, the added interest over the lifetime of the mortgage could exceed the amount of the principal you deferred. You could be paying a significant premium for the switch to an interest-only loan.

Another risk with home equity loans is you may end up owing more than your home is worth. Some lenders will let you borrow more than your home is worth. Or you may borrow less than the current value of your home, but fluctuations in home prices may cause your home's value to drop. Either way, you could end up with negative home equity, making it more difficult for you to sell your home in the future.

Finally, the Federal education loans have a variety of flexible repayment provisions that are not available with home equity loans, such as in-school deferments on the Stafford Loan, interest subsidies on the subsidized Stafford Loan, graduated repayment, and income-contingent repayment. Private education loans may also have flexible repayment terms.

In summary, home equity loans and lines of credit are worth considering, but should be compared with other forms of education financing according to cost, the impact on student aid eligibility, and the flexibility of the repayment provisions.