Home buyers with student loans could find it easier to get a conventional mortgage under some important new rules.
And parents who took on student debt to help their children go to college now have a new refinance option to tap into home equity to pay off those student loans, as well. It might make sense to refinance out of a higher student loan rate into a lower mortgage rate for some, but it's not smart for everyone.
Fannie Mae has re-done its rules to reflect the growing burden that student loan debt has on many households. Outstanding student loan debt now adds up to more than $1.4 trillion, according to the Federal Reserve Bank of St. Louis.
Overall household debt today is just 0.8 percent below its peak of $12.68 trillion reached in the third quarter of 2008, according to the Federal Reserve Bank of New York.
Bill Banfield, executive vice president of capital markets for Detroit-based Quicken Loans, said it became more difficult for many borrowers with student loans to obtain a mortgage when tighter guidelines relating to college debt went into place after the financial crisis in 2008-09. Under the restrictions, he said, lenders had to calculate student debt payments according to certain, generally more conservative formulas when underwriting a new mortgage.
One such calculation: The lender could take 1 percent of the outstanding student loan balance to calculate the potential monthly student loan payment. So a mortgage applicant with $30,000 in student loans would be considered to be paying $300 a month for student loans.
How much you're paying on other debt, of course, influences how much you can afford to pay for a new mortgage.
In reality, though, Banfield said the borrower could be paying far less than that $300 a month under some situations, such as when the borrower has an income-driven repayment plan that reduces their monthly payment.
Under the rule change, the lender now can accept the student loan payment information that's included on the borrower's credit report. For some millennials and other borrowers, the change can help provide more access to a mortgage.
Fannie Mae said its new policies address the obstacles to home ownership that hit because of a significant increase in student loan debt over the past decade.
"We think it's going to help people with student loans qualify," Banfield said. "It's a positive and meaningful change. "It doesn't mean we're taking on more risk necessarily. It just means we're not penalizing people with an overstated payment on their student loans."
Under Fannie Mae's new rules, the lender can take into account student loans that are actually paid by someone else, such as the parent, too. Documentation would be needed to prove that the parent is making the monthly payments on the student loans taken out under the child's name. For example, lenders must obtain the most recent 12 months of checks or bank statements to prove payment by the parent and there can be no delinquent payments in that 12 months.
But if the parent is paying those loans, the younger borrower is better able to take on a monthly mortgage payment. Fannie Mae said that looking at debt paid by others would widen borrower eligibility to qualify for a home loan.
Banfield said it is not unusual to hear millennials say that their parents are making their student loan payments.
Perhaps the parent didn't have savings or want to use their savings to pay college tuition and room-and-board, but the parent feels comfortable paying off a child's student loans over time.
"Who doesn't want their child to have a higher education?" Banfield said.
Sometimes, it's cheaper for a student to take out loans than the parent. For example, undergraduates who obtain student loans get a lower rate than parents under federal student loan programs. The rate on subsidized and unsubsidized federal loans taken out by undergraduates is 3.76 percent for loans taken out between July 1, 2016 and July 1, 2017. The interest rate is fixed for the life of the loan.
By contrast, the current rate is a fixed 6.31 percent for Parent PLUS loans first disbursed on or after July 1, 2016, and before July 1, 2017.
Rohit Chopra, senior fellow at the Consumer Federation of America and former assistant director of the Consumer Financial Protection Bureau, said the new cash-out refinancing option for home owners will likely be marketed to parents who want to pay off some of that student loan debt, too.
Under the new cash-out refinancing program, cash taken out of the equity in the home would go directly to the student loan servicer to fully pay off at least one loan.
Chopra noted that the Parent PLUS loan rate can be higher than the going rate on mortgages. But parents have to make certain that the mortgage rate they'd qualify for when they refinance would be lower than what they are paying on student loan debt.
Another attractive selling point: Mortgage interest is deductible for people who itemize so refinancing could be an advantage to some parents.
But it's important to pay attention to your own tax return and situation. Depending on your income, student loan interest is deductible for some taxpayers. The maximum amount of student loan interest that can be deducted from your income each year is $2,500. If you're in the 25 percent tax bracket, for example, the tax savings would be $625 if you were able to claim the full $2,500. This deduction applies to the interest payment – not the entire payment on your student loans.
The interest paid must apply to qualified education loans, which include federal student loans, private student loans, and parent education loans.
The student loan interest deduction is claimed as an adjustment to income. So you can claim this deduction even if you don't itemize deductions on Schedule A of Form 1040.
And income limits apply. To qualify for the deduction, you'd have to have a modified adjusted gross income that's less than $80,000 if single or less than $160,000 if married and filing a joint return.
But before anyone rushes to take equity out of the house to pay off student debt, ask another question: Will you be putting your home at risk?
If someone has a good paying job and stable employment, refinancing could help. But someone who could face a layoff or a wage cut could be signing away some student loan benefits that can ease the financial pain when a hardship hits.
Borrowers who hold federal student loans and face financial difficulty can tap into attractive deferment and forbearance plans, loan forgiveness options and income-driven repayment plans. By applying for an income-driven repayment plan, a borrower can obtain a monthly payment amount that is intended to be affordable based on your income and family size.
Income-driven repayment options on federal student loans cap federal student loan payments at roughly 10 percent of the borrower's income. These programs are generally targeted at student borrowers, not parents, though some ways exist for parents with Parent PLUS loans to deal with some hardships.
"Swapping student debt for mortgage debt can free up cash in your family budget, but it can also increase the risk of foreclosure when you run into trouble," Chopra said in a news release.