Is this a valid strategy to reduce interest payments for student loans?

Question

I kind of messed up and didn't pay my unsubsidized grad schools loans while I was in school, so I have quite a bit of interest accrued. In total there are 5 loans and they come to about $100k. All of the loans are currently in grace/deferment period. The far right column is accrued interest.

$22,900 @ 6.8% - $2,400
$ 9,700 @ 7.9% - $1,000
$20,500 @ 5.4% - $1,000
$27,000 @ 6.4% - $1,500
$16,300 @ 6.2% -   $250

The loans will enter repayment in July. Right now I have a mortgage ($1,100/mo) and a car loan ($700/mo). I have $8,000 left on the car which I can payoff in the next month or two. Once the car loan is paid off I'm thinking about getting a home equity loan to pay off the high interest student loans. I would need to take out a loan for maybe $40k.

I can payoff the 7.9% loan with cash, and I can almost payoff the 6.8% and 6.4% loans with the home equity loan. This is only if I can get the home equity loan at 4% or less. My bank is advertising 3.8% and I have a good credit score so it should be possible.

My question is will the student loans which are in grace/deferment period affect my current debt to income ratio? My wife and I make $90k/year combined. I know if by debt to income ratio is high I may get a higher interest rate on the home equity loan or the bank may not give me the loan at all. Also our house is worth $130k, and we have $70k left on the house.

Also is this a good strategy overall? I checked into consolidating the loans, but the consolidated loan's interest will just be a weighted average.

Answer 1

There are several concerns with this plan:

• when you take out the home equity loan to pay off the student loan that portion of the debt will no longer be considered student loans.
  • If your income drops for any reason that debt will not be eligible for income based repayment plan,
  • or forgiveness programs for going into public service.
• Your debt will be secured by your house. Fall behind and have your home loan foreclosed.
• Will your monthly income support your repayment of the home equity loan?
  • You have loans in place, that don't need to be approved, and have the possibly of having the payments adjusted.
  • The home equity loan will have a specific interest rate (fixed or variable) and payment period that will set the monthly payment.
• Is there enough room between the value of the house and the current mortgage? The bank may have a cash out refinance limit. If is at 80% you will only be able to get about $34,000.

The bank will look at the remaining student loans when determining how much you can afford in payments each month. If they do approve the loan they will want to have the check written to the student loan accounts as part of the closing process, otherwie you could have both sets of loans.

Answer 2

It's not a bad strategy. I'd rather owe money at 4% interest than at 6-7%. However, there is something to consider.

Consolidating debt into a new loan can backfire. When you have money borrowed at 7%, you want to get that paid off as quickly as possible. Once you have that converted to 4%, if you think, "Now I can take my time paying off this debt," then you aren't really better off. In fact, if you take too long paying off the new loan, you might end up paying more interest than if you had kept the high interest loan and paid it as soon as possible. Don't lose your drive to get out of debt after you refinance.

As far as how the student loans affect your debt-to-income ratio, I'm not sure; however, if they do count (I think they do), your ratio will not really be going up by taking out the new loan, since you are using the money to pay other debt. Make sure the new lender knows this, so they take that into consideration when making their decision.

Overall, I like your strategy: pay off what you can right away (the car loan and the highest interest student loans) and reduce the interest on the rest. Just make sure that you continue to pay down that debt as quick as you can.