Student loans are a stumbling block for many young Americans interested in homeownership. In many cases, these loans increase their debt-to-income ratio to a point where they can't qualify for a mortgage. Others may simply be unwilling to take on a mortgage while paying back student loans.
But some people have taken the plunge into homeownership despite their student loans, or they have taken on this debt by continuing their education after buying a home. For this group, using the home's equity to help pay off their student loans can be a tempting option.
New guidelines from Fannie Mae also make it easier for homeowners to roll student loans into the mortgage. This approach offers the potential for certain savings, but it can also pose some serious risks.
Traditionally, homeowners who want to tap into their equity to pay off a student loan or otherwise get a lump sum of money have used a cash-out refinance. In this option, a borrower refinances their home for a larger amount than they owe and collects the difference. If you have $25,000 in student loans and owe $100,000 on your mortgage, you could refinance for $125,000 to get the money needed to pay off the student loans.
Under the recent updates by Fannie Mae, homeowners can specifically dedicate such funds toward student loans. Bob Sullivan, writing for the financial site Credit.com, says cash-out refinances typically bump up the rate on the new mortgage through loan-level price adjustments, since the borrower is considered to be slightly more at risk of defaulting. With its student loan cash-out refinancing option, Fannie Mae says it will waive the loan-level price adjustments if the funds are paid directly to the student loan servicer.
The borrower must meet a number of requirements in order to qualify for this type of refinancing. They must take out enough money to pay at least one student loan; partial payments are not allowed. The option can only be used to pay off loans the borrower is responsible for, not those of their spouse, children, or others.
Fannie Mae says borrowers could potentially reduce their monthly debt payments through this type of refinancing. Sullivan says the loan-level price adjustment waiver can be up to half a percentage point, allowing the borrower to save thousands of dollars in interest when compared to a typical cash-out refinance.
Homeowners might also be tempted by the idea that they can consolidate their debt into one with a lower interest rate. Karen Lawson, writing for the financial site Lending Tree, says you should compare the principal amounts and interest rates of your student loans and mortgage to see how refinancing can affect your budget. If the rate on your student loans is considerably higher than the rate on your mortgage, you might be able to avoid a significant amount of interest over the years by cashing out to pay off those loans.
Refinancing may also result in a lower monthly payment if you extend the length of the mortgage after you have already paid off some of the principal. Sullivan says you may also be able to get better tax deductions through mortgage interest than you would through student loans.
When calculating whether it is worthwhile to roll student loans into your mortgage, you shouldn't overlook any costs. Refinancing involves starting a new loan, so you'll have to pay closing costs.
The new mortgage will be for a larger amount of money and may extend your mortgage beyond the date you would have paid off your home under the original terms. Even if you take advantage of the new Fannie Mae rules, you could end up losing more money to interest payments in the long run. Starting a mortgage with a longer amortization schedule also means that less of your payments will go toward the principal in the early months of repayment, so you won't build up equity as quickly.
The biggest risk involved in using a mortgage to pay off your student loan is that it replaces an unsecured debt with a secured debt. A lender can't repossess your education if you default on your student loans, although they can garnish your wages or otherwise seek repayment.
A mortgage, on the other hand, is secured by real property. Andrew Josuweit, CEO of the company Student Loan Hero, says that if you roll your student loans into a mortgage and have trouble making payments, the lender can seize your home.
Student loans may be more lenient in certain circumstances. Lawson says some student loans have forgiveness programs, such as federal loans that don't need to be paid back in the event of the borrower's death or certain other circumstances.
If you are considering a cash-out refinance to pay off student loans, consult with a financial adviser, lender, or other professional to understand all of the costs involved. You'll want to make sure that this option is not only able to save you money, but will also be affordable after the mortgage has been modified.