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Though the kid may just be learning to walk, it'll be time to wade through tuition statements before long, so it's not too early to start planning.
But homeowners thinking about throwing extra money at the mortgage in order to build equity for future tuition bills, probably shouldn't, experts warn.
Needless risk
While home equity loans often are a good last resort for parents who have been unable or unwilling to save, they subject homeowners to the whims of the housing market, the vagaries of interest rates and the volatility of their own personal finances -- needless risks for those with plenty of time to save.
Experts say investing in securities would be a better move, because it offers the greatest reward for the smallest risk.
Historically, stock market investors have earned 8 percent to 10 percent each year. At that rate, $10,000 would grow to $36,425 in 15 years, excluding taxes, commissions and other fees. If mom and dad took that same $10,000 and used it to pay down some of the balance on their mortgage, they might end up with enough money to send Junior to Harvard instead of community college, but they'd be taking on a lot more risk and cost since they'd ultimately be getting a new loan instead of cashing in stocks.
Compare the numbers
Assume the folks were five years into a 30-year, 7 percent mortgage of $100,000 on a $125,000 home, for example. Instead of investing that $10,000 in the market, they make a lump sum payment on the mortgage. After the same 15 years, their home equity would be just over $102,000. If a lender was willing to extend 80 percent of the property's value as a line of credit, that would leave mom and dad access to nearly $82,000.
But they'd be facing a monthly payment of $1,025 for 10 years at today's home equity line of credit average interest rate of 8.68 percent -- and paying an additional $40,951 in interest for the privilege.
Worse yet, it may be impossible to even get the second loan since the value of their house might drop, interest rates might skyrocket, and jobs might be lost before it is needed.
Keep options open
"If we get into a situation where money is real tight, you might not be able to get a loan," says Eileen Dorsey, a certified financial planner who owns Money Consultants Inc. in St. Louis. "Once you pay the mortgage payment, if you lose the job and you need that money out of the bank, I don't think they'll give it back to you."
That sentiment is echoed by Ken Kramer, vice president and retail lending manager at Downingtown Financial Corp. in Downingtown, Pa. "Most people who follow the market tend to invest in some kind of mutual or stock fund as opposed to paying the mortgage down for the house."
Consider declining property values and how they might pose a problem. After 15 years, our homeowners would still owe $74,018 in outstanding principal on their house, leaving $50,982 in equity. If their lender was willing to extend 80 percent of the property's value as a home equity line of credit, that would leave them access to $25,982 after subtracting the first mortgage's balance.
Things can change
But if that home's value fell by 2 percent a year during that time, it would be worth just $94,205 when college rolled around. And that would leave the owner with less than $2,000 in equity to borrow under the 80 percent loan-to-value standard.
Fluctuating interest rates threaten to make future borrowing more expensive, too. Indeed, just because rates are low now, doesn't mean they won't rise before college bills arrive.
"What if mortgage rates go up in 15 years? What if interest rates go back to 10?" says Bob Crew, a certified financial planner who owns Heartland Financial Group in Wichita, Kan. "When I bought my first home in the early '80s, the mortgage rate was 12 percent, and a home equity line of credit would be at least that, if not more."
If a borrower's income drops substantially, lenders won't want to extend additional credit, either.
"In St. Louis, a lot of people were losing their job seven years ago or so," says Dorsey. "They needed some extra liquidity, and they couldn't get loans."
Measure the risk
Because of these dangers, financial experts say homeowners shouldn't take the extra step of using a chunk of their equity to invest in the market. Someone in that situation would have to earn a greater-than-average return, they note, while risking their house in the process.
"That's too aggressive and you could end up having a double whammy," Dorsey says. "If you invest it in stocks, and stocks go down for a long period of time, you owe more on your house and you have less to pay it back with."
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