This past week federal mortgage giant Fannie Mae announced it had created a new avenue for its borrowers to pay off student loans: the student loan mortgage swap.
The swap works like this, according to documentation published by Fannie Mae:
- Fannie Mae mortgage borrowers get the benefit
- They do a “cash-out” refinance
- The money from that refinance is used to pay off your loan(s) in full
The concept of this is pretty elegant in our opinion. People who are saddled with student loans – the average grad has about $36,000 in debt at graduation – don’t usually stumble upon a huge chunk of money to pay off those loans.
If you’re lucky enough to own a home that’s gone up in value enough to create a sizeable difference between what your home is worth and what you owe, then Fannie Mae allows you to borrow against that amount (equity) by taking it out as cash you can use on a student loan.
The idea is that your mortgage rate will probably be lower than your student loan rate, which means instead of paying back your student loans at 6.5%, let’s say, you can now pay it back at your mortgage refi rate of, in most cases, less than 4.5%.
Basically, you’re swapping your student loan payments for mortgage payments, which is how this little financial maneuver gets its name.
The news first came out on April 25 in the form of a press release which said the mortgage swap was designed to offer the borrower “flexibility to pay off high-interest rate student loans” and get a lower mortgage rate.
The change was among two others that will, in theory, work in favor of potential or current homeowners who have student loan debt.
“These new policies provide three flexible payment solutions to future and current homeowners and, in turn, allow lenders to serve more borrowers,” Fannie Mae Vice President of Customer Solutions Jonathan Lawless said in the release.
What You Need to Know About Fannie Mae’s Student Loan Swap
Remember how we said that the money you get from your mortgage refinance can be used for a student loan or multiple student loans?
That happens because this refinance is what’s known as a cash-out refinance.
What Is a Cash-Out Refinance?
A cash-out refinance is part of the general class of refinancing.
When you refinance your home, you’re basically selling the rest of what you owe to a lender who’s willing to let you pay them back at a lower interest rate than what you currently have.
The upside is that you have lower monthly payments because your interest rates are lower, but the downside is that your payments are lower because they’re most likely spread out over 30 years, or, at least, longer than what you had left on your original mortgage.
So, you’ll be paying less but you’ll be paying longer.
A cash-out refinance adds a twist to all this. You see, when you do a traditional refinance, you’re borrowing the amount you owe. However, in a cash-out refinance, you actually borrow more than you owe and the lender gives you the difference in cash.
Let’s say you owe $100,000 on your house at 7% with 20 years left. You want to take advantage of a cash-out refi, so you end up refinancing for $120,000 at 4.6% for 30 years.
Assuming all fees are paid for, you get $20,000 in cash. The lender gives you that cash because it’s yours – it comes from the equity in your home.
How the Fannie Mae Student Loan Swap Works
Fannie Mae’s new program takes the cash-out refinance a little further and says that you can only use your cash-out amount for student loans.
However, it’s not that easy. There are certain requirements you have to meet in order to be eligible for the program. Here’s a list of what you need to know:
- The borrower has to have paid off at least one of their student loans
- You’re only allowed to pay off your student loans, not loans other people are paying
- The money must cover the entire loan(s), not just part of it/them
- Your loan-to-value ratios must meet Fannie Mae’s eligibility matrix
We checked the Fannie Mae eligibility matrix and, at the time this article was published in April 2017, the maximum loan-to-value they’d allow on your principle residence was 80% for a fixed-rate mortgage and 75% on an adjustable rate mortgage.
In other words, they want to know that what you owe on the house is, at most, 80% of what it’s worth.
The Pros of Fannie Mae Student Loan Swap: Lower Payments and Interest Rates
The main benefit of a refinance, in general, is that you typically get lower monthly payments that can free up your budget. Those lower monthly payments are due to the length of the refi – usually 30 years – and the lower interest rate you presumably got on your refi.
These lower monthly payments can free up your budget to take care of necessary expenses. Cash-out refinances, in particular, can generate cash to pay for big expenses.
“A cash-out refi is a way to access money you already have in a home to pay off big bills such as college tuition, medical expenses, new business funding or home improvement,” Bankrate’s Janna Herron wrote in an article about cash-out refi’s.
The Cons of Fannie Mae Student Loan Swap: Greater Risk and More Fees
While cash-out refinancing has its advantages, there are some distinct disadvantages.
As Herron pointed out in her article, a cash-out refinance could seriously hurt you if home values fell below what you borrowed. For example, you owe $100,000 on your home and you do a cash-out refi for $125,000. At the time of your refi, your home was valued at $160,000.
A year later, the market tanks and your home value drops to $110,000. Now, your home is worth less than what you borrowed.
Beyond that, the standard cash-out refinancing usually costs an eighth of a percentage more than prevailing rates, even if they are lower than what you’re currently paying on your mortgage, Herron said.
Specific Drawbacks to the Fannie Mae Student Loan Swap
So, now that you know the basics about the pros and cons of a cash-out refi, we’re going to take you to the next level of this discussion: Fannie Mae cash-outs.
Because you’re basically trading a student loan for a cash-out refi, there are some very distinct risks.
A Student Loan Swap Makes Your Debt Secured, A.K.A You’re Risking Your House
First, says Mark Kantrowitz, a nationally recognized student loan expert, you’re trading unsecured debt for secured debt. Sounds like a bunch of jargon, right? Here’s what it means:
Unsecured debt means that someone gives you money with no collateral. They’re not getting anything in return from you for their money aside from your promise to pay them back.
It’s kind of like how when you borrow tools from an auto parts store they want you to pay a deposit as collateral just in case you never bring the tools back.
The Difference Between Unsecured (Student Loan) and Secured (Mortgage) Debt
When a student loan lender gives you money for tuition, there’s no collateral for them.
If you decide not to pay back your student loans, they can’t go inside your brain and take all the information you learned and experiences you had during your college or graduate school years.
All they can do – and don’t underestimate this – is send your account to collections and ruin your credit for the next 7-10 years, or take legal action.
Now, when you do a Fannie Mae student loan mortgage swap, your trading your student loan debt for mortgage debt. You cash-out additional money specifically to pay off your loans.
But guess what? By paying off your student loans with your cash-out money, you’ve now transformed your unsecured student loan debt into a secured debt with your mortgage lender. What’s that mean? If you don’t pay your mortgage and default, they can take your house. Before you did the swap, there was nothing to take.
“Defaulting on a mortgage is more severe than defaulting on a student loan,” Mark told us. “If you default on a mortgage, you can lose your home; if you default on a student loan, the lender cannot repossess your education.”
The Second Main Drawback: You Lose Federal Repayment Options
Another side effect of doing a Fannie Mae student loan mortgage swap is that you surrender your ability to sign up for or continue a federal student loan repayment plan. Whatever your lender says your monthly payments are, that’s what you’re going to pay.
“Borrowers should be careful about refinancing federal loans into private student loans or a home mortgage, because they will lose the superior benefits of federal student loans,” Mark said. “Federal student loans offer deferments and forbearances, death and disability discharges, income-driven repayment and loan forgiveness options that are generally not available on home loans.”
In other words, you don’t have a lot of outs once you turn your student loan into a refinanced mortgage.
This can be particularly rough if you have high loan balances and are using an income-driven repayment plan that reduces monthly payments and offers forgiveness after 20 or 25 years of payments.
A Decent Refinance Requires Decent Credit
One of the advantages to taking out a student loan is that credit scores are not factored when money is given.
The federal student loan forgoes credit checks in order to make tuition assistance available for teenagers who, in most cases, have low credit scores because they have very little credit history.
In other words, you get access to an amount of money you’d never be able to get through a bank or private lender, and especially not at rates below 8%.
A mortgage refinance, on the other hand, is an extensive, invasive process in which pretty much every shadowy and not-so-shadowy corner of your financial life is brought into the light.
If you have bad credit, you’re going to get high-interest rates or you may not even get a loan at all. So, keep that in mind when you’re considering a Fannie Mae student loan mortgage swap.
Though it may sound like an easy way to pay off your loans, your credit may disqualify you from getting one at a competitive rate or at all.
Our Final Thoughts
The Fannie Mae student loan mortgage swap is certainly an innovative way to cut down on your student loan debt via equity in your home.
The pros of this kind of financial product are that, if cash-out refinance rates are lower than student loan rates, then you can stand to save money every month.
And because refis typically last 30 years, your monthly payments will most likely be lower than what they were when you were making payments on your mortgage and your student loan.
The main drawbacks of using a Fannie Mae cash-out refinance to pay off your loans is that you’ll put your home at a higher risk because house values could fall below the amount you borrowed on your refi.
Making a student loan mortgage swap also changes your debt from unsecured to secured. Brooklyn Law School Professor David Reiss reiterated this point in an email to us.
He said that borrowers need to “proceed carefully when they convert unsecured debt like a student loan into secured debt like a mortgage.”
The benefits are great, he said, but the dangers and risks are pretty acute.
“When debt is secured by a mortgage, it means that if a borrower defaults on the debt, the lender can foreclose on the borrower’s home,” David said. “Bottom line – proceed with caution!”
We think what Mark Kantrowitz and David Reiss have pointed out is extremely valuable. While a student loan mortgage swap may seem like a good way to pay off your debt, the fact that it swaps your unsecured debt for secured debt could mean trouble down the road.
Did you find the article helpful? Read more of our advice on student loans:
- The 8 Different Options You Have to Pay Off Your Student Loans
- How to Discharge Your Student Loans via Bankruptcy, Public Service & Payment Plans
- Top Student Loan Scams: Obama Student Loan Forgiveness, Money Up-Front & Other Tricks