- 4 min read
- Review the pros and cons of paying off student loan debt by using equity in a home.
- Understand the risks of turning unsecured debt into secured debt.
- Weigh the cost of both the existing student loan and a refinanced mortgage.
The Pros and Cons of Refinancing or Getting a Second Mortgage to Pay Off a Student Loan.
If you have equity in your home, you may wonder if it pays to refinance your mortgage or take a second mortgage to consolidate student loan debt. This article looks at the pros and cons of using a mortgage to pay off student loan debt. We look at the legal issues, tax implications, and the cost of refinancing.
Financial Issues & Refinancing to Pay Off a Student Loan
The standard term for repayment on a federal student loan is 10 years, although extended and graduated student loan payment terms are available for up to 30 years. Let us assume a person with an undergraduate degree graduated with $20,000 in debt at 5% and a 10-year term on several loans. The monthly payment would be about $215. At the end of 10 years, the total interest expense would be about $5,450 in constant dollars.
Now let us say that upon graduation, a benevolent homeowner completes a cash-out refinance and retires the student's debt. The homeowner refinances at 4% for 30 years (4% is the national average for a prime mortgage as this was written in December 2011). The $20,000 increase to the mortgage balance boosts the monthly payment about $95. At the end of 30 years, the $20,000 mortgage increase will cost the homeowner $14,375 in added interest expense.
Of course, if the homeowner refinanced to a 15-year term, his or her monthly payment would increase by about $150, and the added interest expense would be about $6,600.
Does it pay, financially, to convert student loan debt to mortgage debt? At first glance, no, because stretching the term of the loan increases the interest expense. But there are tax implications that complicate the analysis.
Home Mortgage Interest Deduction
Under federal tax law, the mortgage interest deduction allows homeowners to reduce their taxable income by the amount of interest paid on the loan secured by their residence. If the homeowner already itemizes his or her deductions, then the interest paid can reduce the homeowner’s taxable income amount. However, if the homeowner takes the standard deduction because it is greater then itemizing, there is no tax benefit for the homeowner's mortgage. Roughly half of US homeowners do not take the mortgage tax deduction because, presumably, the standard deduction results in a smaller tax bill.
The cap on the amount of interest a homeowner can claim as deductions on home mortgages is very high. Today, the interest for up to $1 million of home debt can be claimed as a tax deduction.
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Student Loan Interest Deduction
According to the IRS Publication 970, "Any personal interest you pay, other than certain mortgage interest, is not deductible on your tax return. However, if your modified adjusted gross income (MAGI) is less than $65,000 ($135,000 if filing a joint return) there is a special deduction allowed for paying interest on a student loan (also known as an education loan) used for higher education. For most taxpayers, MAGI is the adjusted gross income as figured on their federal income tax return before subtracting any deduction for student loan interest. This deduction can reduce the amount of your income subject to tax by up to $2,500 in 2010."
From a financial perspective, whether a homeowner or borrower should refinance or take a second mortgage to pay off student loans depends on the amount of interest paid on the current student loan and if the borrower’s current income bracket qualifies him or her to get the deduction mentioned in IRS Publication 970.
There is no point in refinancing the student loan to a mortgage unless either the borrower or homeowner are saving a substantial amount on the interest rate. Also, compare the tax benefits with the cost of borrowed funds. Another factor to consider is the closing costs involved in getting a second mortgage.
Legal Issues & Refinancing to Pay Off a Student Loan
The homeowner who refinances to pay off a student loan will burden his or her home with the weight of the loan because it serves as the loan’s collateral. If for any reason the homeowner is unable to keep up with the larger payments, he or she will be putting their home in jeopardy. This is not to say that refinancing or getting a second mortgage to retire student loan debt is always a bad idea. The lesson here is to caution you not to over-extend yourself when refinancing or adding a mortgage.
If you are struggling with debt, you are not alone. According to the NY Federal Reserve total household debt as of Quarter Q2 2022 was $16.15 trillion. Student loan debt was $1.59 trillion and credit card debt was $0.89 trillion.
A significant percentage of people in the US are struggling with monthly payments and about 26% of households in the United States have debt in collections. According to data gathered by Urban.org from a sample of credit reports, the median debt in collections is $1,739. Credit card debt is prevalent and 3% have delinquent or derogatory card debt. The median debt in collections is $422.
The amount of debt and debt in collections vary by state. For example, in Connecticut, 22% have any kind of debt in collections and the median debt in collections is $1427. Medical debt is common and 10% have that in collections. The median medical debt in collections is $490.
Avoiding collections isn’t always possible. A sudden loss of employment, death in the family, or sickness can lead to financial hardship. Fortunately, there are many ways to deal with debt including an aggressive payment plan, debt consolidation loan, or a negotiated settlement.