With mortgage rates near record lows, many student loan borrowers are thinking about using a mortgage refinance to attack their student debt.
The process is called a “cash-out” mortgage. Instead of refinancing the amount currently owed on a house, in a cash-out refinance, homeowners borrower more than what they owe. This means they potentially get a large check at closing.
This option could be very tempting to student loan borrowers with higher interest rates. Someone who owes $140,000 on a house valued at $200,000 could do a cash-out refinance for $160,000. By going this route, the borrower can refinance their home at a lower interest rate, and get a check for $20,000 (minus closing costs) and use that money to pay down student loans.
Using a cash-out refinance could work in certain circumstances, but it comes with risks, and it may not be the best option for most borrowers.
Monthly Savings from Using a Mortgage to Pay Student Loans
Converting student loan debt to mortgage debt can provide a noticeable boost to monthly cash flow.
Generally speaking, monthly loan bills can be lowered in one of two ways: lower interest rates and longer repayment length. A cash-out refinance often accomplishes both. Interest rates can be reduced to the 3-4% range, and monthly payments are essentially spread out over 30 years.
To illustrate the potential savings, suppose we have a borrower with $10,000 of student loan debt at 7% interest on a 10-year repayment plan. By utilizing some of the equity that the borrower has built up, the borrower can get a $10,000 check in a cash-out refinance at 4% on a 30-year fixed-rate loan. In short, our hypothetical borrower has about half the original interest rate and gets 20 extra years to repay the debt.
In this example, our borrower would be making $116 payments on the student loan. If the debt were wrapped into the mortgage through a refinance, the extra $10,000 borrowed would increase the mortgage payment by just $47 per month. That provides an extra $69 per month in cash flow.
A borrower who takes the same steps with $50,000 in student loans would free up over $300 per month!
Another advantage is that the mortgage interest deduction is better than the student loan interest deduction for many borrowers. The student loan interest deduction has income restrictions and a lower deduction maximum. Generally speaking, mortgage interest is preferable at tax time, but the recent 2018 Tax Cuts and Jobs Act (better known as the Trump tax cuts), may change calculations for some borrowers.
However, the monthly cash flow and potential tax advantages come with some financial downside.
The negative is that by spreading out the payments over 30 years instead of just 10, the total spending on interest will be increased. By adding the $10,000 to the mortgage, it will result in an extra $7,187 in interest spending. Had the borrower stuck with the original 10-year repayment plan at 7% interest, the total interest spending would have been $3.933. In short, the longer it takes to repay the loan, the more you spend on interest… even if you have a noticeably better interest rate.
There are also risks to using a cash-out refinance to convert student loan debt into mortgage debt.
Secured Loan Risks
Student loan debt is considered to be unsecured debt. This means that the debt is not secured to any asset or collateral owned by the borrower. If a student defaults on their student loans, their education cannot be taken away.
A mortgage is a classic example of secured debt. If the borrower fails to make mortgage payments, the borrower risks foreclosure. Not making house payments can mean losing the house to the bank.
Adding extra debt to a mortgage means a higher payment. A larger payment is more difficult to handle during a financial hardship.
In other words, borrowers who add student debt to their mortgage risk losing their house because of student debt.
Student loan borrowers can make individualized assessments as to the danger of the student debt leading to a mortgage default. Still, it is something that all borrowers should carefully consider and weigh the risks.
Traditional Student Loan Refinancing vs. a Cash-Out Mortgage
A cash-out mortgage refinance can’t be discussed in a vacuum. Credit-worthy borrowers have multiple options to lock in lower interest rates on their student loans.
In a traditional student loan refinance, sometimes called loan consolidation, borrowers find a new student loan lender to pay off their old student loans. The borrower then repays the new lender according to the terms of the new loan. This approach can often yield significantly reduced interest rates and/or a longer repayment period.
A big advantage to a student loan refinance over a cash-out mortgage refinance is the savings on transaction costs. A student loan refinance has no transaction costs, while a mortgage refinance usually costs thousands of dollars. Expenses that are included in mortgage closing costs like title insurance, recording fees, and appraisals don’t exist with student debt.
Another advantage of traditional student loan refinancing is that the debt doesn’t get combined with the mortgage. This reduces the chances of student debt leading to foreclosure and losing your house.
From an interest rate perspective, the student loan refinance companies are surprisingly competitive with mortgage refinance rates. The refinance rates with many lenders currently start below 2%. However, these excellent rates are limited to 5-year variable-rate loans. The 30-year fixed-rate mortgage offers a borrower far more flexibility. The closest apples-to-apples comparison on rates is to look at the 20-year fixed-rate student loan refinance as it is the longest repayment period that most lenders will allow. In the 20-year fixed-rate category, rates start just under 5%.
Ultimately, the mortgage refi will have better rates and a longer repayment period. The student loan refinance will save thousands from day one because there are no closing costs. Borrowers will have to weigh the interest rate difference against the closing costs when making a final decision.
One Other Option: Borrowers also have the option of using a Home Equity Line of Credit to pay off their student loans. Using this line of credit will normally have lower closing costs than a mortgage refinance, but the interest rate will usually be worse. This line of credit is also a secured debt, so it carries many of the same risks as a cash-out refinance.
Cash-Out Mortgages and Student Debt: Final Thoughts
Using home equity to eliminate student debt can be very appealing, especially when mortgage rates are near record lows.
Unfortunately, there are issues. Even though the borrower is saving some money on interest each month, by stretching out payments over 30 years, the total interest spending ends up being much higher. Combine the higher total spending with closing costs and risk of foreclosure, and the cash-out refinance suddenly looks much less appealing.