Why Is This Mortgage Refinance "Cash-Out"?

June 9, 2003, revised August 20, 2003 "We currently have a first and second mortgage, with plenty of equity left. We would like to take advantage of the current low rates and consolidate the two mortgages into one. Lenders are telling us, however, that because the second is less than a year old, the new loan would be considered cash-out and carry a significantly higher interest rate. Why is this, and is there anything we can do about it other than wait for a year to transpire?" While not all lenders define "cash-out refinance" in the same way, the most widely used definition is that of the two Federal secondary market purchasers, Fannie Mae and Freddie Mac.  Their rules define a cash-out refinance by exclusion, ie, they define an ordinary or no-cash-out refinance, and any refinance that does not meet that definition is considered cash-out.  A non-cash-out refinance is one that a) is used to pay off a first mortgage, and/or junior mortgages that were used in their entirety to buy the subject property; and b) is for an amount not in excess of the loan balance, plus settlement costs, plus 2% of the new loan amount or $2,000, whichever is less.  If the borrower has a mortgage balance of $150,000 and settlement costs are $5,000, for example, the loan can be no larger than $157,000.  Any refinance that does not meet these specs is a cash-out refinance and will carry a higher interest rate.  The major reason for the higher rate is that studies of delinquency and default indicate that borrowers who do a cash-out subsequently have poorer payment records than borrowers who don�t. The presumed reason for this is that borrowers who need cash are financially weaker than borrowers who don�t, and in some cases they may be in financial distress. Your transaction does conform to the no-cash-out definition because your second mortgage was not used to acquire your home.  While you don�t need cash now, you did need cash when you took the second mortgage. If you were in financial distress then, perhaps you still are.  In the view of Fannie Mae and Freddie Mac, that is an element of additional risk.  You must have spoken to portfolio lenders -- those who originate loans to hold rather than to sell in the secondary market.  Some of those might apply an older rule that says that after a second mortgage is on the books for a year, it is no longer an indicator of additional risk.  You might want to go back to these lenders after a year elapses, when they will no longer view your loan as cash-out.  The much more numerous lenders who sell in the secondary market will continue to view your deal as cash-out. Copyright Jack Guttentag 2003

Jack Guttentag is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Visit the Mortgage Professor's web site for more answers to commonly asked questions.

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