October 16, 2018 – By Mia Taylor
It’s hardly a secret or news flash that the student loan debt crisis in this country has reached epic proportions.
For those who’ve lost track of just how bad things have gotten, here’s an update: There are now more than 44 million borrowers in America who collectively owe over $1.5 trillion in student loan debt. The only debt category that’s higher than student loan debt is home mortgages.
Looked at another way, the amount owed on student loans is higher than either credit card debt or auto loans. That’s no small feat given the collective consumer penchant for cars and credit card spending.
As Americans struggle to deal with student loans, Fannie Mae has dangled a carrot of sorts. The government sponsored mortgage giant now offers what’s known as a student loan cash-out refinance. The program enables participants to use equity in their homes to pay off student loan debt as part of an overall mortgage refinance.
At first blush, it sounds tempting, doesn’t it? Who wouldn’t want to eliminate a monthly student loan payment while also potentially lowering the interest on that debt, given that the average mortgage rate has been slightly lower than student loan interest rates in recent years?
Before becoming giddy over the possibilities, it’s important to note that experts far and wide urge approaching this program with a huge, huge amount of caution. Because with the benefits, come many risks and drawbacks.
How the Student Loan Cash Out Refinance Works
Fannie Mae’s program allows participants to use their existing home equity to pay off one or more student loans, potentially reducing overall monthly debt payments.
The upshot of the offer is that the loan-level price adjustment, which is the risk-based fee assessed to mortgage borrowers on cash-out refinances (typically in the form of a higher interest rate), will be waived for those using the money to pay off student loans.
In order to qualify for this perk, at least one student loan must be paid off by the refinance. And the money from the refinance must be paid directly to the student loan servicer at closing.
Risk No. 1: You’re Putting Everything on the Line
Let’s start with one of the biggest concerns experts have about the student loan cash out refinance, which is that you’re putting a lot on the line when opting for this approach.
Katie Ross, education and development manager for financial education non-profit American Consumer Credit Counseling, suggests the risks easily outweigh the benefits.
“If all of your eggs are in one basket, you risk losing everything all at once. Your home will essentially become collateral for your student loan debt,” explained Ross, who added that you’ll also pay more interest over time on the debt when refinancing it into one large lump sum; it will take longer to repay your mortgage because a refinance increases the length of your mortgage, and you lose out on student loan debt relief options.
But let’s break down some of those concerns in more detail.
Risk No. 2: Important Protections Are Lost
One of the big benefits of federal student loans is that when you hit tough financial times — such as losing a job, or when you’re earning very little income — there are programs available to help. The options include income driven repayment programs or even deferring the loan entirely for a time.
When student loans are rolled into a mortgage, however, those benefits are lost. All of them.
“If you lose your job you have multiple options to restructure your student loan based on income. It’s mind boggling there are so many options. But you lose the option to restructure the loan if you put it on mortgage,” explained Beverly Miller, a Pittsburgh-based personal finance coach.
What’s more, by combining your student loan with your mortgage, you also lose out on the opportunity to participate in any employer assisted repayment of the student debt or the chance at loan forgiveness (which is available to certain public service workers, teachers, or those who are disabled).
Risk No. 3: You’re Putting Your Home at Risk and Eliminating Equity
Rolling a student loan into a mortgage significantly increases the amount you owe on your house. And when your financial situation takes a turn for the worse, you’re still required to keep paying the mortgage.
Add a student loan to the mortgage mix and you may have even more trouble making the payments when money is tight. What’s more, if you try to sell the home when times get tough, there’s no guarantee you’ll be able to sell it for enough money to cover a mortgage that now includes the student loan debt.
This approach to tackling student loan debt also eats into the equity you’ve created in your home. And that’s no small downside.
“If you’ve had a home loan for quite some time and built up equity, when you refinance and pull cash out to pay off a student loan, you’re starting all over again with your mortgage,” said Faramarz Moeen-Ziai, vice president at Commerce Home Mortgage in Walnut Creek, Calif.
Risk No. 4: Missed Tax Deduction Opportunities
The standard deduction was raised as part of the new tax laws that took effect in 2018. Single taxpayers now get a standard deduction of $12,000, while for head of household filers it’s $18,000, and for a married couple filing jointly it’s $24,000. Given these increases, many filers will cease itemizing deductions this year. As a result, mortgage interest will no longer be deductible for those unable to itemize.
However — and this is a key point — student loan interest is still allowed as a deduction, whether you itemize or not. But those who roll student debt into their mortgage lose the student loan deduction.
“One things people don’t realize is that student loans are an above-the-line deduction, an adjustment to gross income,” explained Bob Harkson, partner at Phase 2 Wealth Advisors in Gig Harbor, Wash. “So, if you wrap your loan into your mortgage, you lose that benefit.”
Remember, You’re Just Reshuffling Debt
Experts also stressed that it’s key to keep clear in your mind that you’re not eliminating student loan debt when taking advantage of a student loan cash-out refinance. You’re simply shifting that debt or reshuffling it.
“You are fooling yourself into thinking that you’re getting rid of your debt,” said Miller, the Pittsburgh-based personal finance coach. “You’re just moving it and you may lose the motivation you had to pay it off, because it is now hidden from you in your mortgage.”
The Bottom Line
While refinancing a mortgage to pay off a student loan isn’t for everyone and comes with certain risks, some of the professionals interviewed for this story said they’ve helped clients with a student loan cash-out refinance. In some cases, it can be a worthwhile option, particularly if you’re having significant trouble making student loan payments each month. But review your financial situation and your future plans very carefully.
“Be sure you’re staying in home for a while, because if you get a job transfer and have to move, and housing prices have dropped, the question becomes how do you sell your home if you’re upside down?” said Harkson.
For those who have 50% to 60% equity in a home, the risks are not as high, because even if housing values slide, you may still be able to sell the property if need be and not owe any money.
“It doesn’t hurt to look at it and see if you qualify,” added Harkson. “But be aware of the pitfalls. There is a dark side to it potentially. We have a full employment economy, the stock market is going strong, and everyone is feeling strong, but those things always come to an end — so beware.”