There are two types of “good” debt—student loan debt, and housing debt. These forms of debt are considered good because each helps the borrower create capital in different ways: Borrowers who spend money on higher education are investing in “human capital” or earning potential, while borrowers who buy a home can build up equity in their property.
However, for many Americans, these two types of debt also compete with one another. Adults with student loan debt say it hampers their ability to qualify for a mortgage. Homeowners carrying high-interest student loans atop a mortgage may not have much money for other necessities—such as saving for the future or investing for retirement.
The good news is that the debt pinch for student loan borrowers may be loosening. In spring 2017, government sponsored enterprise Fannie Mae, which influences borrowing rules used by lenders, issued a series of changes designed to make it easier for first-time buyers with student loans to qualify for a mortgage.
Fannie Mae also began supporting mortgage refinance options allowing homeowners to refinance high-interest student loan debt into lower-interest mortgage debt, reducing the total loan interest paid over a lifetime.
Are these programs right for you? Possibly, say many planners.
“Any time there are more options, it’s better for the consumer,” says John Flavin, a certified financial planner with Synergy Financial in Seattle. “Why not take the better terms?”
Understand the rules for buyers and owners
Before you can benefit from the new student loan debt options, it’s important to understand how they work. Under new rules proposed by Fannie Mae, two changes improve a first-time borrower’s ability to qualify for a mortgage. Both are designed to lighten the way lenders look at debt when calculating a borrower’s “debt to income” (DTI) ratio, which is a key metric lenders look at to determine a loan applicant’s ability to repay debt.
The first change: Lenders can now use different formulas when counting debt from income-based student loan repayment programs, which are popular among borrowers who either work in lower-income professions or who have larger loan balances. The second: Lenders will now exclude debt from DTI calculations if borrowers can document that they receive regular outside help paying student loans, such as from family or an employer benefit programs.
For homeowners, new rules permit borrowers with sufficient home equity to refinance their mortgage and pull cash out to pay off a portion or the entirety of their student loans. Student loan-focused home refinancing rules may offer slightly better terms than other cash-out refinancing options.
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Pros of the programs
For new buyers, the ability to get into a home while repaying student loan rates can be very beneficial. Educated adults tend to earn higher incomes over their lifetimes and own homes in higher proportion than non-college educated adults, so the proportional student loan burdens should shrink as home equity accrues—in effect, rising home values help wipe out student loan debt.
For existing homeowners, home-related loan interest is typically lower than student loan interest. It is also tax-deductible. “Any day you can lower your rates on debt is a good day,” Flavin notes. “Saving a few percentage points on what is typically five-figure debt on a student loan can free up hundreds of dollars per month which can go towards emergency reserves, retirement investing, or accelerated mortgage loan payoff.”
Cons of the programs
“Buyers of new homes and those refinancing to wipe out student loans need to discuss with a planner how these choices will impact their financial flexibility,” Flavin says.
According to Flavin, if a home loan and a student loan are kept separate, one benefit is that in the event of hardship the student loan balance can typically be deferred or frozen. If the student loan is rolled into the home mortgage via a refinancing, however, there is no such forgiveness available on this portion of household debt.
An example of this point: If the owner of a $300,000 home had $50,000 in student loan debt and fell into a tough economic period, and they paid $2000 toward their mortgage and $500 toward student loans each month, they could potentially defer the student loan payments during tough times—a meaningful “break” while working through a tough time. With student loan debt refinanced into a mortgage, though, the homeowner might have a $2500 mortgage and no options to postpone debt.
Understand your loan terms
As with any debt, it’s important to understand your loan terms—so you know the true benefit of the loan you’re starting with and the financial benefits of the new loan you could use to replace the old loan.
“Debt isn’t necessarily bad,” Flavin notes, “managing debt badly is bad. Getting into a home while carrying heavy student loan debt may prove risky for some borrowers, even if underwriters will offer a loan. But with home prices rising, the new rules can be very beneficial for borrowers to get into a home—and then refinance to pay off student loans.”
“Homeowners who refinance and cash out to pay student loans should remember flexibility,” he says.
“You could go for a 15-year home loan with a slightly higher required payment, or you could go for the 30-year home loan and just pay it off rapidly,” he says.
“We always want clients to have flexibility.”
Ultimately, it seems, lenders want the ranks of the indebted educated to also have flexibility to buy homes and use their home equity to erase student loan debt. With student loan debt an ongoing reality, the new possibilities for borrowers under revised lending rules and for homeowners under revised refinancing rules could make for healthier household balance sheets.
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