Parents: Be Careful With These Student Loan Alternatives

With FAFSA delays pushing back the date many students will find out how much financial aid they're eligible for this year, some parents are keeping their eyes peeled for alternative college funding options. If their dependent doesn't qualify for enough scholarships, grants, and federal student loans to cover tuition and fees for the 2024-25 academic year, the thinking goes, they may be able to use these funding alternatives to fill in the gaps.

There are also families who want to avoid over-borrowing for higher education, thus they're willing to consider alternatives to student loans for that reason alone. And, who can blame them? We are currently in the midst of a student loan debt crisis , with American families on track to borrow $100 billion in new student loans for the 2024-25 academic year alone.

Unfortunately, most student loan alternatives come with downsides that diminish any upsides derived from avoiding or minimizing student loans. Add to that the myriad benefits that come with federal student loans families could miss out on, including future student loan forgiveness plans , access to income-driven repayment plans, and the option for federal deferment or forbearance.

We all know the best way to pay for excess college expenses is with cash you have saved in a 529 plan or a savings account, but that's not always possible. If you're considering alternative ways to borrow for school, you should know about potential pitfalls that could apply.

Home Equity Loans And HELOCS

With home prices nearing all-time highs across large swaths of the country and future growth predicted to continue, homeowners who have stayed put for a while could easily find that they're cash poor but rich in home equity. In that case, a home equity loan or home equity line of credit (HELOC) makes it possible to borrow against the increases in a home's value and pay it back over time.

There are some differences between home equity loans and HELOCs, including the way payments are determined and the type of rates they charge (fixed or variable), However, both types of loans have one major factor in common. Home equity products use the value of the property itself — the family home — as collateral.

While secured loans like home equity loans can offer lower interest rates since they are secured with collateral, using a property you live in to secure a loan should never be done without careful consideration.

"The big risk here is you are putting your house at risk for this debt," said financial advisor Lawrence Sprung , who is also the founder of Mitlin Financial.

"Should you run into financial issues paying down this debt, it could mean losing your home."

According to Sprung, home equity should only be used for improvements to the home or debts you know will be able to be paid off in a relatively short period, regardless of economic conditions. After all, improvements to the home funded with home equity should theoretically improve the value of the property commensurate with the money spent.

Furthermore, the rates on HELOCs or Home Equity Loans may not be much better than the current rates on Federal student loans anyway .

Roth IRAs

Some families also turn to retirement funds, and specifically Roth IRAs, to help pay for college expenses when funding runs dry or cash is tight. Roth IRAs are popular for higher education expenses since savers can withdraw their contributions (but not earnings) without paying taxes or a penalty at any time. If you use the funds for qualified higher education expenses , you can also avoid the penalty on your gains (you would still have to pay regular income tax).

As usual, there's a cost that comes into play if you decide to use this "free money" for higher education expenses or anything else you want to fund that isn't your retirement. According to Sprung, the big risk here is using retirement money for other purchases (including college tuition and fees) at the expense of actually being able to retire one day.

Sprung points out that taking large sums from your Roth IRA to pay for higher education is especially risky since you will miss out on forfeited earnings. You are also limited in terms of how much you can contribute across IRA accounts you have each year, meaning it can take a long time to replace any funds you use.

For example, contributions across all IRA accounts are capped at $7,000 for most taxpayers in 2024. However, those ages 50 and older can contribute an additional $1,000 in catch-up contributions each year.

Giving up that money during prime earning and compounding years can be very expensive in the future.

401(k) Loans

The same general risks apply with 401(k) loans , which let individuals borrow against their retirement funds and pay the money back (plus interest) to their own accounts. When you borrow against a retirement account like a 401(k), you are missing out on potential earnings and growth you would likely have if you left your account alone.

There are additional problems with 401(k) loans, including the fact not all retirement plan administrators offer this option in the first place. Limits for 401(k) loans can also come into play. These limits are currently set at 50% of a person's vested account balance or $50,000 (whichever is less), per the Internal Revenue Service (IRS).

Also be aware that losing your job or moving companies could leave you having to pay back the full amount you borrowed right away, depending on your plan administrator. And if you find you're unable to pay the loan back based on the terms you initially agreed to, any unpaid amounts could become a plan distribution to you. This means you could potentially get hit with taxes on these amounts, as well as early withdrawal penalties.

The Bottom Line

While it's easy to believe other loan options could leave you better off if you need extra funding for college, federal student loans are almost always the best option. There are several reasons for this, but most of them boil down to the government protections that come with federal student loans.

"Should you run into issues paying your student loans, there are many options available to stay on track while not causing further financial harm to you or your other assets," says Sprung.

If you borrow for higher education using your home's equity or your retirement funds, on the other hand, you'll have almost nowhere to turn if you run into trouble paying the money back. And if you wind up not having enough money saved for retirement because you treated your 401(k) or IRA like a piggy bank, it could easily be too late to do anything about it.

By Robert Farrington, Senior Contributor