But now that Sec.11043 of the Tax Cuts and Jobs Act is in effect, the tax deduction for interest paid on home equity loans used for any purpose other than home improvement is suspended until 2025. The tax law changes apply to any home equity loan, including those opened before 2018.
For parents who were using a home equity loan to pay for all or part of their child's college expenses (or had planned to), this change may signal the need to take a closer look at whether using a home equity loan to pay for college still makes financial sense.
Determine the true financial implications of the suspended tax deduction
The federal financial aid system (FAFSA) doesn't officially take one's home equity into account when calculating how much a family can borrow to pay for college, and any opportunity to reduce the overall cost of college offers a financial reprieve. The average annual tuition and room and board expenses at a public, four-year school now total about $21,000 for an in-state resident, according to the College Board's data. Yet, the actual value a family gained by using home equity loans to pay for college before the tax law changed (or how much they'll lose now that it's in effect) is highly dependent on the borrower.
For example, the New York Times reports that before the tax law change, a parent with $20,000 outstanding on a home equity loan who paid 4.5% interest on it (annually) would have been able to deduct about $900 in annual interest. For parents with several children to put through college, the loss of that deduction could indeed mean they'll spend several thousands of dollars more on college-related expenses.
However, parents may still be eligible for other education-related tax benefits, including the American Opportunity Tax Credit (AOTC), which allows those pursuing a degree to receive a tax credit for qualified education expenses up to $2,500 (per eligible student) for the first four years of higher education; income limits are $90,000 modified adjusted gross income (MAGI) for single taxpayers, or $180,000 for married taxpayers filing jointly. If a child or parent is eligible for employer tuition assistance programs, those benefits are not subject to any tax, up to $5,250 per year.
Plus, parents who meet the income limits of $80,000 MAGI for single taxpayers, or $165,000 for married taxpayers filing jointly, may deduct up to $2,500 in student loan interest on their federal tax return. Given the gradual interest rate increases that have taken place over the last year, the financial appeal of a home equity loan to pay for college may have already diminished, especially for borrowers whose credit doesn't allow them access to the most competitive interest rates, or those whose home equity loan has a variable interest rate. By contrast, federal student loans offer a fixed interest rate, the aforementioned tax benefit, and potentially, the option to defer repayment and/or lower the amount that must be repaid, based on the college graduate's profession.
529 plans have become more flexible
Once limited to higher education expenses, funds in a 529 savings plan can now be applied to any education expense (though pre-college expenses are limited to $10,000 per year). Earnings in a 529 savings plan are not subject to federal income tax, and distributions aren't subject to federal or state income tax if used for qualified education-related expenses. The expanded functionality of the plans could mean more state-level tax deductions for parents depending on the 529 plan they use, and their state of residence. Parents who planned to fund college with a home equity loan may instead want to increase contributions to a 529 plan to ensure it is adequately funded to pay for pre-college and college expenses.
Consider a different approach to using home value
As the experts in Financial Planning explain, parents may now realize more financial benefit by tapping into their home's value by way of a mortgage refinance. There is now a $750,000 maximum limit on that deduction, but by refinancing a primary mortgage, parents may have an opportunity to roll debts related to college expenses into a new mortgage loan. While using a home's value to fund college may not have been seen as a particularly risky move amid the backdrop of a strong housing market, it's important for parents to remember that tapping into home equity to pay for college could put their greatest asset in jeopardy. In fact, some experts feel home equity loans can be a gateway of sorts into other types of debt, by creating the illusion that there is more cash on hand than is actually available.