Whether you’re already a homeowner or getting ready to buy, here’s everything you need to know about the relationship between student debt and mortgages.
How A Cash-Out Refinance Could Help You Pay Off Student Debt
Good news, as of Friday, December 4, the U.S. Department of Education extended the pause on student loan repayments put into place as a result of the coronavirus pandemic through January 2021. That means if you have student loans, you don’t have to resume payment until February of next year. The average student loan payment is $400 a month (Federal Reserve Bank of NY).
If you’re one of the many Americans who has student loan debt (approximately 45 million borrowers in the US), but want to purchase a home, you can do it! Check out our blog, How to Buy a Home When You Have Student Debt. If you’re already a homeowner, but have student loans and are preparing for the repayment plans to restart in February, you may be able to use a cash-out refinance to help pay your debt down.
For Homeowners
It’s no secret that mortgage interest rates are low right now. But refinancing may seem like a foreign or intimidating concept. So let’s start with what is a cash-out refinance? A cash-out refi allows you to access a portion of your home's equity and turn it into cash. It replaces your existing mortgage loan with one that is greater. The difference goes to you in cash to use as you like. It’s a way for you to get cash from your home without selling it.
You can use this cash for anything, but because you may be subject to additional fees and a new interest rate, it’s best to use the money smartly, like paying down high-interest debt.
Pros of a Cash-Out Refinance
- Lower interest rates. A refinance typically offers a lower interest rate than a home equity line of credit, or HELOC, or a home equity loan, especially if you purchased your mortgage at a time when rates were higher.
- Student debt consolidation. You can use the cash you get from your refinance to pay your student loans down quicker. This might be helpful if you’ve been enjoying the student loan forbearance period and want to “make up” for that time. You may be out of the habit of making student loan payments or are used to setting aside the money for other things and need a lump sum to pay it down.
- Tax deductions. You may qualify for the mortgage interest deduction if you use the cash to improve your home.
Things to Consider With a Cash-Out Refinance
- New terms. Your new mortgage loan will have different terms, rates, and fees associated with it. Send us a message or give us a call and we’ll figure out those numbers for you. You’ll have to pay new closing costs for this transaction, as you would with any refinance, which typically run from 2-5% of the loan amount. Do the math to make sure the savings will balance these costs.
- Private Mortgage Insurance. If you borrow more than 80% of your home’s value, you will have to purchase private mortgage insurance (PMI). Private mortgage insurance typically costs from 0.55% to 2.25% of your loan amount each year.
- Enabling money habits. A cash-out refinance can mean big savings if you’re using the cash to pay down high-interest debt like student loans. But be mindful when using the cash for other things like paying off credit cards or personal projects. It could lead to more debt if you use it as a crutch.
For Future Homeowners
If you’re looking to purchase a home, but are currently paying off student loans (or are preparing to commence after the forbearance period ends), keep reading.
Let’s demystify the assumption that you need to be completely debt free to qualify and apply for a mortgage. Lenders don’t necessarily look down upon debt - what’s more important is your debt-to-income ratio (DTI). Your DTI is a comparison of the money you owe vs the money you bring in. If your DTI is low enough, it shows that you can manage your debt well and taking another debt like a mortgage loan is possible.
Take a look at how your student loan debt compares to your overall debt and total income. Depending on how much of your student loan you have left to pay off, you may have a higher DTI and need to spend time paying down that loan.
But you don’t need to completely pay off your student debt to qualify for a mortgage. Other factors are just as important such as reliable income, credit score, other debt management history, and potential down payment savings.
If you’ve acquired a stable job and have developed smart money habits: if you have an emergency fund, a low DTI, you’re saving for retirement, and you’re on a solid student loan repayment plan, you might be ready to become a homeowner!
Consider your options. If you do have a higher DTI because of your student loans, you may not qualify for a conventional loan, but rather a government-backed loan. Research different loan types and talk to a mortgage professional to explore your options.
Pay off other debt. If you have other debt like credit cards on top of your student loans, focus on paying that down too, to lower your overall DTI. You can still work towards buying a home while you pay down your debt.
While there are possibilities for another stimulus check, an extension of the student loan pause, and even some loan forgiveness from the new administration, none of that is certain. It’s best to assume that loan payments will resume in February as currently stated and plan your 2021 financials around that. Any changes will be a welcomed bonus! But know that homeownership is a possibility for you even if you’re managing student loans!