retirement

Savings goals: Retirement trumps college

Don TaylorQuestionDear Dr. Don,
I am halfway through a 15-year mortgage with about $115,000 remaining at a mortgage rate of less than 5 percent. I am thinking about refinancing to a 15-year (adding eight years) to pull about $100,000 out for helping our three children pay for college. The payment would jump by about $400 per month.

We are also saving for college as we go. The children are already/will be taking Stafford loans. This would be to help with the difference. I also have a 401(k) that I contribute the maximum to each year. Do you think this is a smart move?
-- John Juncture

AnswerDear John,
A cash-out refinancing is one way to help pay for college costs for your children. You'll get a great rate on the debt, and the mortgage interest should be tax deductible on your federal income taxes. IRS Publication 936, "Home Mortgage Interest Deduction," explains the deductibility in greater detail.

I like to remind parents that college funding shouldn't be their first priority as a financial goal. Retirement savings should have a higher priority. It's great that you're maxing out your contribution to a 401(k) plan while also saving for the children's college.

Maxing out 401(k) contributions, however, doesn't necessarily mean you're saving enough to fund your retirement. The new mortgage will have a claim on your household income for the next 15 years.

If you can manage it financially and it is a family goal to help with or provide a college education for your children, funds allocated to this goal need to be part of the household spending plan.

I'm not sure where you have the monthly payment going up by $400 per month. You only approximated your current market interest rate as being south of 5 percent with seven years remaining on the loan.

I entered 4.875 percent as the mortgage rate and compared it to Bankrate's national average for a 15-year fixed-rate mortgage of 4.18 percent. That has the monthly nut being about the same as your existing mortgage payment, which means it is as affordable as your existing mortgage.

You can use Bankrate's mortgage calculator to construct a table with your actual numbers, but with a good credit score, it should be close to these results:

Mortgage scenarios
Existing mortgageDirect PLUS student loanCash-out refiCash-out refi w/additional principal payments
Loan amount$115,000$100,000$215,000$215,000
Interest rate4.875 percent7.9 percent4.18 percent4.18 percent
Loan term (months)8412018089
Monthly payment$1,618.65$1,208.00$1,609.79$2,817.79
Total payments$135,966.90$144,959.81$289,762.58$250,355.03
Total interest$20,966.90$44,959.81$74,762.58$35,355.03
Closing costs N/A$2,000.00$2,000.00
Total expense$20,966.90$44,959.81$76,762.58$37,355.03

For reference, I included the cost of a 10-year Direct PLUS student loan, financing $100,000 at 7.9 percent. This isn't all that realistic because you're likely to take out these loans as needed over time rather than all at once.

Still, if each PLUS loan is made with a 10-year term, and at the 7.9 percent interest rate, the total interest expense will match the interest expense presented here -- it's the payments that will fluctuate based on the loan amount outstanding at any point in time.

I like the mortgage option over the student loan option because it isn't putting additional strain on your monthly budget. You should be able to continue to fund your retirement account and provide some college savings.

If you have the slack in your monthly budget to pay an additional $1,200 per month, you could apply it to principal on the cash-out refi by making additional principal payments each month. This would bring its total expense down to approximately $37,355 and shorten the loan term to almost the loan term of your existing mortgage.

Without the additional principal payments, you're paying about $54,000 (pre-ax) in additional interest expense to finance $100,000 of college expenses. It sounds expensive, but part of the interest expense ($19,000) is in extending the term of the existing mortgage loan. The cash-out refinancing should be the best approach to continue working on all your financial goals.

In terms of your 401(k) plan, continue contributing at least up to the limits of your company's matching contributions. Past that point, you have to decide if it makes more sense to contribute to a Roth IRA or a traditional IRA.

The ability to make after-tax contributions to a traditional IRA and then convert to a Roth IRA adds an additional wrinkle to the mix. Consult with your tax professional if you can't decide where these contributions should go.

Get more news, money-saving tips, and expert advice by signing up for a free Bankrate newsletter.

Bankrate's content, including the guidance of its advice-and-expert columns and this Web site, is intended only to assist you with financial decisions. The content is broad in scope and does not consider your personal financial situation. Bankrate recommends that you seek the advice of advisers who are fully aware of your individual circumstances before making any final decisions or implementing any financial strategy. Please remember that your use of this Web site is governed by Bankrate's Terms of Use.

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