Is It OK to Pay for College With a 401(k) or Home Equity Loan?

Q. I need to borrow $10,000 for my son’s college in the fall. I can’t decide if I should outright take a loan, borrow from my home equity or take a 401(k) loan. Help!!

A. All of your borrowing options have potential long-term consequences, so we’re glad you’re thinking this through.

Although it can be tempting to borrow against your home or your 401(k) to help pay for college costs, you may want to think twice before doing so, said Charles Pawlik, a certified financial planner with Lassus Wherley in New Providence, N.J.

“Borrowing against your home versus taking out federal education loans can look appealing from an interest rate perspective, and in light of the rebound in home prices since the recession,” Pawlik said. “However, it is important to keep in mind that adding more debt to your home in lieu of utilizing federal student loan programs available to parents and students can lead to problems with your home down the road.”

Pawlik said the primary reason interest rates on home equity loans are typically more attractive than federal education loans is because home equity loan debt is secured by your home, giving the lender a legal claim to your home in the event of default. Using equity in your home to pay for college costs instead of a federal education loan effectively converts the loan into secured debt — debt that is backed by a personal asset, in this case, your home.

Plus, federal student loans typically offer a variety of protections in terms of repayment options, as well as forgiveness benefits, that are not available with a home equity loan, he said. In this way, you give up flexibility by utilizing a home equity loan to pay for college costs, in addition to running the risk of foreclosure on your home if you can’t pay back the loan.

(It’s also important to know how taking out student loans or borrowing against your home can affect your credit. You can get a better understanding of your credit by regularly checking your credit reports and credit scores. You can also get a free credit report summary on Credit.com, updated every 14 days to watch for important changes.)

Then there’s the 401(k) loan option.

Pawlik said it’s a bad idea for several reasons.

First, you’ll be losing out on potential tax-deferred earnings on these funds. Furthermore, some plans won’t allow you to continue to make pre-tax contributions to your 401(k) until you’ve paid off your loan.

“This could amount to years that you don’t have the ability to add to your 401(k) accounts while losing the benefits of tax-deferred growth on those contributions as well as the reduction in taxable income you receive from making pre-tax contributions,” he said.

You also incur double taxation on a loan from your 401(k), given that you will be repaying the loan with after-tax money and then be taxed on those funds again when you withdraw them in retirement, Pawlik said.

If you can’t repay the loan, you may be subject to taxes and penalties.

“The loan balance will be treated as a distribution, which triggers income taxes and a 10% early withdrawal penalty if you are under age 59½,” Pawlik said.

And if you quit or lose your job, plans typically require the loan balance to be repaid in full within 60 days, Pawlik said. Otherwise, you will be considered in default on the loan and be subject to the same income taxes and 10% penalty on these funds.

Pawlik said because the options all have risks, you may want to speak to a financial professional for help so you make an informed decision based on your overall situation, and help to ensure that you aren’t putting yourself at risk in your effort to assist your children with paying for school.