A Student Loan Hero user recently asked us an interesting question: “Should I dip into my home equity to pay off my student loan debt?”
This strategy is referred to as “debt reshuffling” via a Mortgage Equity Withdrawal, Cash-Out Refinancing or a Home Equity Line of Credit.
Basically, you would refinance your current mortgage with a new loan or add a home equity loan to an existing mortgage that allows you to free up cash already paid towards the mortgage. Then, you use the freed up cash or new debt to pay off your student loan debt.
Why would someone consider “debt reshuffling” as an option?
- Take Advantage of a Lower Interest Rate (and pay less interest)
- Lower Monthly Payments
- Enroll in Unique Programs (like tax breaks or GOV benefits)
Refinancing to pay off student loan debt might seem to add up on paper, but it’s actually risky when you consider the consequences. Let’s investigate the consequences, when this debt repayment strategy makes sense and the financial breakdown.
Risk 1) Student Loans and Mortgages Don’t Mix
Your mortgage is considered a secured debt, which means that it is tied to an asset (in this case, your house) and your house is considered collateral against the debt owed. If you fall behind on mortgage payments, the bank can seize your home through foreclosure.
A student loan, on the other hand, is unsecured debt and the bank cannot seize your house or car if you fall behind on student loan payments (although they can garnish your wages). Lastly, you can declare bankruptcy on a mortgage whereas student loans are much more difficult to discharge in the case of bankruptcy.
What’s this all mean? Well, if you transfer student loans to your mortgage and can’t afford the new monthly payments, you put your home at risk of foreclosure. A good rule of thumb is to make sure your Debt-to-Income ratio stays within a manageable range, typically below 36% (as most experts say), and you are in a stable job environment to comfortably make monthly debt payments.
If you can’t afford your current monthly payments you shouldn’t add student loans to a mortgage, and consider an alternative income driven student loan repayment program, such as Income-Based Repayment.
Risk 2) Interest Rates Don’t Add Up
Compare mortgage interest rates vs. student loan interest rates. If you have a higher interest rate on your student loans than your mortgage, you accrue interest faster and can potentially save money by rolling the student loan debt into a mortgage with a lower interest rate.
Mortgage Refinancing can also be an effective tool for lowering monthly payments. On the flip side, if you have student loans with low interest rates (typically below 4%) it is difficult to find a lower interest rate via refinancing.
Risk 3) A New Term Can Cost You Thousands
Refinancing student loans into your mortgage theoretically extends the term of the original student loan debt from 10 to 20 or 30 years with a typical mortgage. With a longer term on the mortgage, you will end up paying more interest over time.
Risk 4) Hidden Costs and Terms
Be sure to include closing costs into your financial analysis, as this can easily add several thousand dollars to your mortgage. Also, be on the lookout for unfavorable mortgage terms that can trap you in a variable interest rate loan longer than you want.
Lastly, the longer term you choose for your mortgage, the more you will end up paying in accrued interest over time.
In Closing – Do Your Homework!
Be sure to speak with a Certified Financial Professional and Licensed Mortgage Broker before pursuing “debt reshuffling.”
If you’re interested in refinancing your mortgage, you may be able to lower your rate and monthly payments. Click here to compare mortgage rates in our Marketplace.