Ask Dr. Don By Don Taylor, Ph.D., CFA • Bankrate.com

Financing college costs

Dear Dr. Don,
We have a daughter going to college this fall. We never set up any kind of college account. We only have four years left on our mortgage, which means we have quite a bit of equity.

We were offered the Federal Stafford Loan, which is capped at 9 percent. I understand the rate changes annually. I don't know whether to refinance our home, take a home equity loan or just go with the Federal Stafford Loan. I am looking for some advice as the time to make a decision is getting near.
Thank you for your time,
Teresa Tuition

Dear Teresa,
There are three types of Federal Direct Stafford/Ford loans available plus a student loan consolidation program. The loan descriptions presented here come from the U.S. Department of Education's Direct Loan FAQ page.

I'm assuming you've been through the Free Application for Federal Student Aid (FAFSA) and your daughter has received her Student Aid Report (SAR). The student aid report will state whether she's eligible for a subsidized loan. If she is, then that should be the first place to borrow because the government pays the interest expense while she's in school and during any grace or deferment periods.

Federal Direct Stafford/Ford Loans (Direct Subsidized Loans)
Students must demonstrate financial need to receive this type of loan. (The school determines financial need based on the information provided on a financial aid application.) The federal government pays the interest on these loans while students are in school at least half time and during certain periods, such as grace and deferment.

Federal Direct Unsubsidized Stafford/Ford Loans (Direct Unsubsidized Loans)
Students can get these loans regardless of financial need but will have to pay all interest charges.

Federal Direct PLUS Loans
Parents of dependent students can get these loans to pay for their children's education. Parents are responsible for all interest charges.

Federal Direct Consolidation Loans
These loans combine one or more federal education loans in one new Direct Loan. Only one monthly payment is made to the U.S. Department of Education. In certain circumstances, students who have loans under the Federal Family Education Loan Program may consolidate them into Direct Loans.

The interest expense on student loans may be tax deductible. Tax Topic 456 -- Student Loan Interest Deduction describes when the interest expense can be used as a tax deduction with more information available in IRS Publication 970, Tax Benefits for Education. If the student loan interest will be deductible then you won't need to take on mortgage debt to gain the tax deduction.

With only four years to go on your mortgage, there's not a compelling reason to refinance. Most of your monthly payments are going to principal reduction, not interest. The closing costs on a new first mortgage make it even harder to justify doing a cash-out refinancing. A home equity line of credit (HELOC) or home equity loan is a better choice.

A HELOC is revolving credit, like a credit card, with a variable interest rate. You run the risk of higher rates over time, similar to the interest rate risk you take on with the variable rate student loans, but without the 9 percent interest rate cap. An advantage to the HELOC is that you can make interest only payments until you've paid off your first mortgage and then work on paying down the loan balance. You can also draw against the credit line as you need it, so you don't have to worry about how you're going to invest the loan proceeds until the college bills come due.

A home equity loan will have a fixed interest rate and a fixed payment schedule. If you borrow four years worth of college expenses all at once, you'll have to reinvest the proceeds. The interest expense on these funds, even on an after-tax basis, may be more than the after-tax income from these investments, increasing your expenses.

Look for loan options where you can deduct the interest expense, borrow when you need funds and be able to meet the projected repayment schedule. Decide what part of her college expenses will be your daughter's responsibility and what you're willing to take on yourself.