Should you roll your student loans into your mortgage?
College graduates with student debt soon will have a new option: the ability to roll those student loans into their home mortgage. Fannie Mae, which works with virtually every lender in the country, has created a new standard that will allow borrowers with sufficient home equity to fold their student loan balances into their home mortgages.
But is that a smart thing to do?
The answer isn't clear-cut. Turning student debt into mortgage debt could cut the interest rate and payments required of some debtors. However, it also strips away some of the protections that come with federally guaranteed student loans. Those who might need those protections may want to forego the program. But those who have significant home equity – and significant student debt – should take a close look.
Here's what you need to know to decide whether the program is right for you:
How does it work?
Those with sufficient home equity and income will be able to execute so-called "cash-out" refinances, in which you get extra money to pay off other debts, said Jon Lawless, vice president of product development for Fannie Mae. In this case, the additional cash would be earmarked to repay student debt that you owe or have co-signed for.
There's no specific dollar limit on how much student debt can be repaid this way. However, the Fannie Mae program restricts your total mortgage debt to that of a "conventional" loan. Conventional loan limits range between $424,100 and $636,150, depending on where you live. (High-cost areas, such as Alaska, Hawaii and major cities, such as Los Angeles and New York, qualify for the higher limits.)
In addition, the new loan cannot exceed 80 percent of the home's value. And the borrower has to qualify for the higher loan amount based on normal underwriting standards, which typically expect that your mortgage payments won't exceed one-third of your gross income.
What's the difference between student debt and mortgage debt?
The biggest difference is that all types of federally insured student debt offer two compelling benefits: the ability to put payments on hold when you're in school, out of work or disabled, and the ability to pay based on your income.
Mortgage loans -- and some private student loans -- provide neither of these breaks. Once you secure a mortgage, you cannot pay less than the amount you agreed to, unless you refinance the loan at a lower rate of interest or stretch out the repayment. If you fail to pay on a mortgage, the lender can foreclose, causing you to lose your home.
Of course, if you default on a student loan, the repercussions are also severe. But because of the ability to tap flexible repayment plans, the need to default even after a job loss is considerably lower.
Student loans aren't all alike
They come in many types, and some may be smarter to refinance than others. For instance, you should think twice before you roll so-called Perkins loans, subsidized Stafford loans and subsidized consolidation loans into a mortgage. That's because the government will pay the interest on these loans if you put them into "deferment" to go back to school or because you lost your job. That can save you thousands of dollars.
Other types of student loans -- direct, PLUS, unsubsidized Stafford loans and private loans -- also may allow you to put payments on hold, but interest accrues during those "deferment" periods, which can dramatically boost the amount you owe. These loans are better suited to rolling into a mortgage.
Pay attention to interest differentials
If you have a low-rate student loan, refinancing it into a mortgage loan may not make sense. But if you have a higher-cost (or variable-rate) private or so-called PLUS loan, you may be able to save a bundle by refinancing. Fannie Mae's Lawless said its research found that most student borrowers paid between 4 percent and 8 percent on their student debt, while the current average rate for a 30-year fixed-rate mortgage is around 4 percent today.
How much might refinancing save if you're on the high end of that range? Consider, a hypothetical borrower we'll call John, who financed law school with PLUS loans. John now has a $100,000 balance at an 8 percent interest rate. With an extended repayment plan amortized over 30 years, the monthly payment on this loan amounts to $734. If he can refinance that balance into a 30-year mortgage at 4 percent, his payment would drop to $477.
Refinancing saves John $257 per month and a whopping $92,520 in interest over the life of the loan.
What about taxes?
Interest paid on a home mortgage is generally tax-deductible. Some student loan interest may also be deductible, but those deductions are limited based both on the borrower's income and by the amount that can be written off each year. Taxpayers who itemize deductions and earn substantial amounts -- thus paying income taxes at higher federal rates -- would benefit the most from rolling student loans into a mortgage.
Repayment options
With student loans, you can generally change your repayment plan by consolidating your loans. This can be helpful if you're having trouble paying as much as you promised. In fact, the government offers a number of income-based repayment options that will allow you to pay based on what you can afford.
Mortgages don't offer that option. If you think there's a strong possibility that you'll need to pay less -- you're planning to go to graduate school, for instance, or your job is unstable -- you shouldn't fold student loans into a mortgage because you lose that option.