What are the Downsides to Using Home Equity to Refinance Student Loan Debt?
October 22, 2012
I have almost $200K in student loan debt at interest rates from 6.5% to 8.5%. My parents are offering to take on $70K of my debt that’s at 8.5% by way of a mortgage they have access to at 3.5%, provided that I am able to pay it off in 3 years. Given my current job situation, I can handle the monthly payment to them ($2K) in addition to the monthly payment for my remaining loans ($1,100 a month over 10 years) without any major problems. The plan is, once I’ve paid off the first $70K loan from them, the remaining amount would be cycled into their loan. This sounds like a no-brainer for me, given my amazingly supportive parents. Are there any downsides to paying off loans like this? Should I be concerned about losing qualifications for pending legislation that would allow total loan forgiveness, such as the Student Loan Forgiveness Act of 2012? — S.R.
Substituting a 3.5% rate loan for an 8.5% rate loan will save a significant amount of money. Refinancing $70,000 in student loan debt that is currently at 8.5% with a 3.5% interest rate will save about $160 per month and about $5,700 over the 3-year term of the loan. Using a 3-year term saves an additional $24,600 as compared with a 10 year term.
There are, however, a few risks associated with such a refinance.
Federal education loans have fixed interest rates. Mortages, home equity loans and home equity lines of credit may have either fixed interest rates or variable interest rates. If the 3.5% rate loan has a variable interest rate, that rate could rise, increasing the cost of the debt. It is reasonable to assume that variable rates will rise during the economic recovery by about the same amount as they fell at the start of the economic downturn, by about 5 to 6 percentage points.
However, the Federal Reserve has indicated that it will continue to suppress interest rate increases through 2015. So long as the variable rate debt is paid off in full within the next three years, the interest rate is unlikely to increase by much.
The main risk is that the borrower will not be able to pay off the $70,000 loan in three years. Refinancing the student loan debt into a 3-year term increases the monthly payment by almost $1,200. A salary reduction or job loss might make it more difficult for the borrower to afford the higher loan payments. This could stretch the parent’s debt into a longer term loan, increasing the likelihood of an interest rate increase. This could ultimately cost more than keeping the loan at a higher fixed rate.
Even if the borrower successfully repays the $70,000 loan in 3 years, he shouldn’t count on being able to continue at a 3.5% interest rate for much longer than that.
Note also that federal student loans offer several options for financial relief that are not available to mortgage borrowers. For example, unemployed borrowers can get the economic hardship deferment for up to three years. The federal student loans also offer income-based repayment and public service loan forgiveness.