Question: I graduated from college with a LOT of student debt. In my case, I’ve been able to get good jobs and make solid money because of my education. At the same time, I’ve been thinking that since the value of my home has increased during the past few years.
I’d like to refinance and get rid of my student debt entirely. Is this possible?
Answer: At the end of July, Fannie Mae – a major buyer of mortgages nationwide – announced that it was changing its student loan policy in a way that will reduce costs for those with student debt.
This is good news for those with education loans. Let me explain.
First, student debt is soaring. According to the Federal Reserve Bank of New York, at the end of the first quarter student debt amounted to $1.34 trillion. That’s up more than five times from 2004 when “just” $260 billion was owed.
Second, monthly payments for student loans count as recurring debt when you apply for a mortgage.
Third, as of July, interest rates for new federal student debt range from 4.45 percent to 7 percent, far more than the cost of a typical mortgage. Refinancing from student debt to mortgage debt can reduce expenses and monthly costs.
Lenders look at your debt-to-income ratio (DTI) when reviewing a mortgage application. Basically, they look at how much of your monthly income goes to repaying certain bills.
If the DTI is too high, the application will be declined and financing won’t happen.
Recently, DTI standards have been loosened and some lenders will now allow a 50 percent DTI as opposed to usual 43 percent. With a higher DTI, you can have more debt and still get a mortgage.
For instance, if you have a gross household income of $6,000 a month, then with a 43 percent DTI as much as $2,580 is allowed for recurring debts such as mortgage expenses, car payment, credit card bills, and student debt.
Bump the DTI in this example to 50 percent and the lender will allow you to devote as much as $3,000 a month to ongoing debts.
The lending world has been okay with paying off student debt with long-term and sometimes cheaper mortgage financing. But, technically, when you pay off a student loan, it’s seen as cash-out refinancing. Lenders get skittish when cash is taken out of a home, and borrowers face a higher rate in the form of something called a “loan-level price adjustment.”
Now Fannie Mae is changing the rules. As of the end of July, the loan-level price adjustment can be waived for student debt. That means you pay less for refinancing than what you would have before the new rule went into effect.
According to the new Fannie Mae guidelines:
- “At least one student loan must be paid off. Loan proceeds must be paid directly to the student loan servicer at closing.”
- “Only student loans for which the borrower is personally obligated can be paid through the transaction.”
- “Student loan debt must be paid in full with the proceeds — partial payments of student loan debt are not permitted.”
If you look at the new rules you can see several issues.
First, you cannot get the lower rate if you pay off someone else’s student debt. This stymies family members who would like to help a relative with education bills.
Second, the student debt must be completely paid off, so partial payments do not qualify. If you think about professions with high tuition bills such as doctors and lawyers — professions where six-figure education bills are not unknown – this can inhibit refinancing because a home may not have enough free equity to pay off the entire student debt bill.
Third, there is a DTI trade-off of sorts. When looking at the DTI, the lender will see smaller payments for student debt, but perhaps larger mortgage costs because more is being borrowed, depending on interest rates, loan amounts, etc.
Will a lot of people dump student loans in favor of bigger mortgages?
We don’t know the answer yet, but with growing real estate equity and an end to the loan-level price adjustment it will not be surprising if refinancing to end student debt becomes more common.
In some cases, refinancing with a mortgage will result in a lower interest rate and a longer potential repayment period, two features which can lead to smaller monthly payments and a reduced DTI hit.
For more information speak with mortgage loan officers, check the numbers, and see if refinancing student debt can work for you.