Kate asks: We can borrow equity against our home at 4%. Is it worth it to take out an equity loan to pay off our student loans (undergrad and graduate), the bulk of which are locked in at 6.8%? Also, I'm close to paying off my undergraduate student loan. Should I put the money I was placing towards that loan each month into savings or into paying off my graduate student loans? We are credit card debt free and at this rate will be free of all student loans in three years.
Home equity loans can be a relatively cheap way to borrow versus personal loans and credit cards, thanks to their low interest rates. But with only a few years left to pay off your student loans, it’s important to calculate your total interest costs over the life of that new equity loan. While 4% is a more attractive rate than the 6.8% on your student loans, the equity loan offered may have a much longer term than three years, meaning you’d need to pay back that loan for a much longer period of time and continue paying that 4% interest for several more years. (You could prepay the equity loan, but there may be a penalty.)
Let’s say your loan balance is $5,000. Paying that off in three years at 6.8% interest will cost about $541 in total interest payments. On the other hand, if you take out a $5,000 10-year equity loan fixed at 4%, your total interest payments will be about double that, or $1,074.
“The total interest cost -- even at 4% -- may be higher than she thinks,” says Keith Gumbinger, VP, HSH.com, a mortgage information web site. “Even with a five-year loan, that's two extra years of interest charges, even at a lower rate.”
Damien emails: I'm getting crushed by my monthly student loan payments. I'm currently on a 10-year repayment plan for my Stafford and Grad PLUS loans. Does it make sense to extend repayment to 30 years (thus, lowering my monthly amount due), but then prepaying each month to avoid the "more interest over time" problem? Even if I end up paying the same each month, wouldn't this chip away at the principal faster?
While extending the repayment term will lower your monthly payment, paying the same as you are currently won’t reduce the principal’s balance any faster than the term on your original loan, according to Mark Kantrowitz, publisher of Fastweb.com and FinAid.org and author of “Secrets to Winning a Scholarship.”
He offers this example: Suppose you owe $20,000 in unsubsidized Stafford loans with an interest rate of 6.8%. The monthly payment on a 10-year term is $230.16 and the monthly payment on a 20-year term is $152.67. If you were to switch from a 10-year term to a 20-year term but still pay the same amount as required under a 10-year term, applying the difference ($230.16 - $152.67 = $77.49) to the principal balance of the loan, the loan will be paid off in full in 10 years. You’ll have paid just as much toward the interest and principal as the original loan.
“If you are having difficulty making the monthly loan payments, you should seek a repayment plan with monthly loan payments you can afford,” says Kantrowitz. “Do not choose a longer repayment term than you need, because more interest will accrue, increasing the cost of the loan. For example, increasing the term of an unsubsidized Stafford loan from 10 years to 20 years reduces the monthly loan payment by about one-third, but more than doubles the total interest paid over the life of the loan.”
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