Dear Dr. Don,
At 26 years old, I'm graduating next semester with a bachelor's degree. I'm three years into my career with a good job. My wife and I own a home with substantial equity. We have no credit cards or debt other than student loans.
Regarding the latter, I have about $50,000 in student loan debt. Most of the debt -- $30,000 -- involves Stafford loans in my name carrying a rate of 6.8 percent after graduation. The remaining $20,000 is tied to PLUS loans at 7.9 percent. While these are technically loans made to my mother, I make the payments. Unfortunately, I don't get the tax benefits.
Our mortgage is about 70 percent loan-to-value with payments amounting to 20 percent of take-home pay. We are three years into a 30-year mortgage at 3.75 percent. The house is worth about $150,000. We purchased the home as a foreclosure in a premium area and have extensively remodeled it.
One issue with the current mortgage is that we will pay $100 a month for the next three years for private mortgage insurance since the equity in the property came from remodeling it. We plan to keep the loan term at 30 years for flexibility and to allow for aggressive retirement savings of $450 a month, but are open to suggestions.
Assuming I can still get 3.75 percent, I am wondering if it makes sense to use some equity to pay down the PLUS loans, taking advantage of the lower interest rate and tax benefits.
Any advice would be greatly appreciated!
-- Eric Equity
You're in good financial shape for someone just graduating from college.
The goal is to minimize your total after-tax expenses on the mortgage and student loan debt. At issue here is choosing the right way to restructure the loans. If your appraisal is realistic, then cash-out refinancing should relieve you of the PMI payments.
That saves you more than $3,000 over the next three years. When involving a refinance, lenders are cautious about how much cash you can take out. You'll also have to pay closing costs.
As I write this, Bankrate's national average for a 30-year fixed-rate mortgage is 4.28 percent. Whether you can replace your existing mortgage with added debt less expensive than what you got with your student loan could be a challenge.
A home equity line of credit typically has lower closing costs, but will carry a higher interest rate compared with a mortgage. You also won't be able to avoid PMI on the existing mortgage.
The following is an estimate of the pretax expense associated with the two scenarios. They are a cash-out refinancing versus sticking with your existing loan and taking out the home equity line of credit. It assumes you can replicate your existing mortgage rate in a cash-out refinancing. I don't think that is likely.
Cash-out refi vs. combining HELOC with existing mortgage
|Loan term (months)||360|
|Total interest expense||$81,400.37||$65,714.34|
|Total pretax expense||$83,800.37||$70,064.34|
This gives you an idea of the numbers for your review. Part of the reason I prefer combining a HELOC with your existing loan assumes you pay off the home equity line in 10 years. That's a reasonable assumption since the PLUS loans you're making payments on now should have a term of 10 years. Good luck!