Are you drowning in student loan debt? If you’ve tried managing the balances on your own but haven’t had much luck, a home equity loan could be a viable option to get much-needed relief. Before employing this strategy, it’s worth understanding the key advantages and disadvantages so you’ll know what to expect.
Understanding Home Equity Loans
Before diving into the pros and cons of using a home equity loan to pay off student loans, you should familiarize yourself with how this debt product works.
What is a Home Equity Loan?
A home equity loan is a type of installment loan that acts as a second mortgage. It lets you borrow against the equity you’ve built up in your home and use the funds however you see fit.
How Do Home Equity Loans Work?
Lenders generally cap the amount of equity you can pull out at 85%. So, if your home is worth $355,000 and you owe $197,000, you could potentially access up to $104,750 ($355,000 * .85 – $197,000) in cash.
If you decide to proceed, the lender will disburse the funds in a lump sum. The interest rate is fixed, so you’ll make equal monthly installment payments over a set period—typically up to 20 years.
Can You Use a Home Equity Loan to Pay Off Student Loans?
There are no spending restrictions on home equity loan proceeds, which means you can use the funds to consolidate student loans.
Types of Student Loans
Here’s a closer look at the two types of student loans:
- Federal: These loans are issued by the federal government and typically come with lower interest rates and flexible repayment options.
- Private: These loans are offered by banks, credit unions and other financial institutions, generally with less flexibility and higher rates.
Interest Rates and Repayment Terms
Interest rates on home equity loans are typically lower compared to student loans since they are secured by collateral. It’s also important to note that while federal student loans have fixed interest rates, private student loans sometimes come with variable interest rates. And with the latter, it can be challenging to manage fluctuating monthly payments.
So, by consolidating with a home equity loan, you’ll get a more predictable monthly payment. Whether your loans are federal, private, or both, you can save a sizable amount of money in interest.
Challenges in Repaying Student Loans
Remember, home equity loans use your home as collateral. So, if you consolidate using this approach and encounter financial challenges that cause you to fall behind on the payments, you risk losing your home.
It’s also worth noting that you lose the borrower protections that come with federal student loans if you pay them off with a home equity loan.
Using a Home Equity Loan to Pay Off Student Loans
Below is a closer look at the key benefits and drawbacks of using a home equity loan to consolidate student loan debt.
Advantages of Using Home Equity Loans for Student Debt
- Lower Interest Rates: It’s possible to get a lower interest rate with a home equity loan than you’re currently paying. This is especially true if you have private student loans.
- Single Monthly Payment: Instead of making several monthly payments to student loan servicers, you’ll get a single monthly payment by consolidating.
Potential Disadvantages
- Risk of Foreclosure: As previously mentioned, following behind on the home equity loan payments could put your home at risk of foreclosure.
- Home Value Fluctuations: If you tap into your equity and your home value dips, you could be left with far less equity than you anticipated.
Eligibility and Requirements
Before applying for a home equity loan to pay off your student loans, it’s best to get a feel for the general lending guidelines. That way, you’ll know if you’re a good fit for a home equity loan or if you need to improve your financial profile or credit score before moving forward.
Assessing Home Equity and Loan-to-Value Ratio
Lenders assess your loan-to-value ratio to determine your eligibility for a home equity loan. An LTV ratio of 85% or lower is preferred for the best approval odds.
To find your LTV, divide your mortgage balance by your home’s current market value and multiply the result by 100. To illustrate, if your home is worth $400,000 and you owe $250,000, your LTV is 62.5% ($250,000 / $400,000 * 100) and would be deemed acceptable in the eyes of lenders.
Credit Score and Income Requirements
Your credit score is another vital factor lenders consider when reviewing your application for a home equity loan. It should be at least 620, although some lenders may go slightly lower with other compensating factors.
Lenders also look at your debt-to-income (DTI) ratio, which represents the percentage of your gross monthly income spent on debt payments. It should be below 43% to get approved. So, if you earn $6,000 monthly, your debt obligations should be below $2,580 for the best approval odds.
Application Process for a Home Equity Loan
Here’s what the application process looks like:
- Step 1: Research lenders
- Step 2: Get prequalified with at least three and choose the best option.
- Step 3: Formally apply for a home equity and submit the required documents.
- Step 4: Await the results of the appraisal ordered by the lender to determine your home’s current market value.
- Step 5: Receive the final clear to close from the underwriting department.
- Step 6: Review and sign the loan documents.
- Step 7: Receive the loan proceeds.
Required Documentation
Before applying, gather these documents to help streamline the lending process:
- Proof of identity, like a driver’s license, passport or state-issued identification card
- Proof of income, including most recent pay stubs or tax returns
- Mortgage statements that show your current balance loan terms
- A copy of your home appraisal if you have it handy
This list is not all-inclusive but provides a great starting point. Reach out to your lender to find out what additional documents they may need.
Steps to Convert Home Equity into Cash for Student Loans
Below is a breakdown of what to expect when moving forward:
- Step 1: Assess your home equity. Subtract your current mortgage balance from your home’s market value to determine how much equity is available in your home.
- Step 2: Check your credit score. Most lenders prefer a credit score of at least 620 to qualify for a home equity loan. That said, a higher score will likely grant you access to more competitive terms.
- Step 3: Choose the right loan product. Explore home equity loans, HELOCs, and cash-out refinances to decide which is right for you.
- Step 4: Research lenders. Get loan quotes from at least three lenders and compare them to identify which offers the best deal.
- Step 5: Formally apply. Complete the loan application in its entirety, review for errors and submit. Be sure to include the requested documentation to avoid processing delays.
- Step 6: Seal the deal. Once your home appraisal and underwriting processes are complete, sign the loan documents, receive the loan proceeds and pay off your student loans.
Conclusion: Is Using Home Equity to Pay Off Student Loans Right for You?
Tapping into your home equity to pay off student loans can be a smart financial move. But before moving forward, check your credit, run the numbers and confirm you have enough equity to access through a home equity product. Most importantly, keep the risks of this approach in mind before deciding if it’s ideal or if you should pursue another path to consolidate student loan debt.
