Ask Money

Retire student loans with home equity–not

Chris Farrell Feb 1, 2011

Question: I have an adjustable rate mortgage with a principal of $255,000; I’m going to refinance to a fixed rate this month and I expect a rate between 4 and 5%. I also have student loans of $35,000 with an interest rate of 6.25%.

Is there any reason not to take enough cash out to pay off my student loans? It seems like an obvious decision, but I want to make sure that I’m not overlooking anything. Thank you! Kristina, San Francisco, CA

Answer: I would not take money out of your home equity to pay off your student loans. It’s a risky strategy to save a percentage point or two on your loan. (I am assuming these are federal student loans.)

The big advantage of keeping the federal student loans is financial flexibility. Let’s say you get into a financial bind. Maybe you lose your job or confront a medical emergency. You have a number of options to buy yourself financial relief with the student loans.

For instance, with economic hardship you can apply to suspend repayments for up to three years. Another option is to slash your monthly tab by shifting to the income-based repayment plan. Most borrowers have a monthly payment of less than 10% of gross income with the income-based loan. (You can learn more about income-based repayment here.)

However, you lose the financial flexibility embedded in the debt obligation once it’s turned into a mortgage payment. Mortgage companies don’t care about economic hardship. Forget deferment or forebearance, let alone an income-based repayment plan. No, can’t pay the bill? They’ll foreclose on you. This scenario has happened to far too many people ever since the real estate market went bust.

Now, there is a case for your strategy if these are “private” student loans. The term is really a misnomer. These are consumer installment loans with a different label. The private lenders offer none of the built-in flexibility of federal student loans. You can’t discharge private student loans in bankruptcy, either. (The same holds for federal student loans.)

Still, if they’re private student loans and you decide to pay them off with home equity I would make sure you have a hefty cash cushion left over to withstand any setbacks. However, I remain wary of tapping into home equity to even payoff private student loans. I’d rather you preserve the equity and devise a plan for attacking the student loan debt more aggressively. It’s a safer way to save on interest costs.

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