With nearly 44 million Americans saddled with $1.4 trillion in student loans, Fannie Mae is offering those with houses an opportunity to wipe out the debt through refinancing their mortgage. But the option carries as many risks as rewards.
This week, Fannie Mae said lenders who sell loans to the mortgage finance giant can participate in a new program, dubbed the Student Loan Cash-Out Refinance, that helps borrowers pay down education debt. Homeowners with college loans taken on their behalf or for their children can refinance their mortgage and pull out the home equity as cash. The lender uses that cash to pay off the student debt, leaving the homeowner with a larger mortgage at a potentially lower interest rate.
Considering that Fannie Mae works directly with an estimated 2,000 lenders, the policy change could have far-reaching effects. The new policy is built on a similar refinance program that the mortgage giant introduced last year with SoFi. It also taps into an existing marketplace where borrowers can use a line of credit, home-equity loan or other cash-out programs to pay off student debt.
But those options can be costly. Second home loans often carry higher interest rates than first mortgages, and many cash-out options have higher interest rates than standard refinancing, said Jonathan Lawless, vice president of customer solutions at Fannie Mae.
“We looked into whether we could remove that cost … and thereby stimulate that activity of leveraging equity to pay down student debt,” he said. “We explored it with SoFi and realized we could take it further.”
Even though mortgage rates have ticked up in recent months, they remain historically low, with the 30-year fixed-rate average at 3.97 percent. Rates for federal student loans are also at their lowest level in a decade — 3.76 percent for undergraduates and 6.31 percent for Parent Plus loans. Private lenders, meanwhile, offer student loans with interest rates that range from 3.9 percent to 12.8 percent based on the borrower’s credit and whether there is a co-signer.
Rohit Chopra, a senior fellow at Consumer Federation of America, said the cash-out refinancing option makes the most sense when the new mortgage rate is substantially lower than the rate on the student loans. Homeowners with older government loans at much higher rates or those with pricey private loans could do well under the program, as long as they have “solid income and a stable job,” he said.
There is also a tax benefit for high-income earners who opt for the cash-out program. People who make too much money to qualify for the student loan interest deduction may see greater tax benefits through the mortgage interest deduction, which is not subject to the same income limitations.
“A refinance is a complicated transaction; you’re changing the terms on your loan, you’re changing the interest rate across two loans,” Lawless said. “Look at APR and payment over the life of the loan, and not just your monthly payment. You want to go into it thoughtfully.”
Fannie Mae estimates that 8.5 million households could use the cash-out refinance option to get rid of their student loans. Roughly 41 percent of those homeowners are in debt for their own education, while more than a third co-signed loans for their children or grandchildren. According to Fannie Mae, the average homeowner with co-signed student loans has a balance of $36,000 and those with Parent Plus loans hold an average balance of $33,000.
“Borrowers with a lot of home equity can often get mortgage rates that are substantially lower than the rate on their student loan, which is why parents may be the target for this program,” Chopra said. “Parents have student loans with higher rates and tend to be sitting on more home equity than new homeowners.”
The program may not be a good fit for everyone.
Homeowners with federal student loans run the risk of losing a host of protections, including the right to defer payments during a bout of unemployment and access to programs that limit monthly payments to a percentage of earnings. They would also miss out on loan forgiveness available to people who work in the public sector. Lawless said Fannie Mae is disclosing such risks.
There are fewer tradeoffs, however, for people with federal Parent Plus loans. Those loans are only eligible for what’s known as income-contingent repayment, which caps monthly bills at 20 percent of disposable income and forgives the remaining balance after 25 years. Since private loans are also bereft of federal consumer protections, there is less risk in rolling them into a mortgage.
Still, consolidating education and housing debt into one loan is a gamble. If you lose your job and default on the mortgage, the bank could foreclose on your house. But if your federal student loans are separate from your mortgage and you’re enrolled in an income-driven repayment plan, you wouldn’t have a monthly bill while you’re unemployed, freeing up cash to cover other responsibilities.
“Losing your home is the most catastrophic financial event you can experience, and a lot of homeowners have a difficult time modifying their mortgages when things get tough,” said Chopra, a former student loan ombudsman at the Consumer Financial Protection Bureau.
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