Use home equity to pay off student debt

03/31/2008

QUESTION:
Dear Joe,

My daughter and son-in-law are considering taking out a home equity loan to pay off his student loans. They think the interest rate will be lower. Is this a good idea, or should they try to work with the student loan people to consolidate as best they can? These are private student loans.

-- Cheryl

ANSWER:
Dear Cheryl,
By all means, they should consider refinancing those loans with a home equity loan.

I'm not surprised to hear that your daughter and son-in-law can find a home equity loan with better terms than what his current loans carry. Banks will usually offer a lower interest rate when the loan is secured by the equity in real property. A private student loan typically has no security other than the personal guarantee of the borrower and (often) a co-signer.

Furthermore, home equity loans are often available at a fixed rate of interest, whereas private student loans are usually variable-rate. For many borrowers, a fixed rate is more appealing if they wish to avoid the possibility of interest-rate increases in the future. In comparing options, be sure to consider the upfront costs of a refinancing or loan consolidation.

Your daughter and son-in-law should also consider the income tax consequences of refinancing the student loans. They may currently claim a federal tax deduction for up to $2,500 in student loan interest paid each year, although the deduction phases out above a certain income level. For 2008, the phaseout range for joint filers is $115,000 to $145,000 in adjusted gross income.

Interest on up to $100,000 of home-equity indebtedness is deductible regardless of income, but only if the taxpayers are itemizing their deductions and are not subject to the alternative minimum tax, or AMT.

There is a downside of going with the home equity loan. Your daughter and son-in-law risk losing their home if their finances go sour and they are unable to keep up with their payment obligations. On the other hand, such an outcome is unlikely if your son-in-law sticks with private student loans.

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