Mortgage to Purchase, or Afterwards?

December 19, 2005, Revised January 25, 2006, Revised March 10, 2006

"I have enough cash to swing a all-cash purchase if I want, but I don’t want all my money tied up in the house, I want to get some of it back in a mortgage. What is the down side of paying cash and taking out the mortgage later versus taking out the mortgage at the time of purchase?"

The Case For Paying Cash and Refinancing Afterwards

It is more difficult to shop effectively for a purchase mortgage than for a refinance. Borrowers purchasing a house are faced with a closing date on which they must provide funding to complete the purchase. This means that at some point in the process there is not enough time for the purchaser to back out of a deal and start anew with another loan provider. Once past that point, they are vulnerable to a variety of tricks by unscrupulous loan providers that can cost them dearly.

In contrast, the refinancing borrower who feels badly treated by a loan provider can opt out of the deal at any point and start again with another loan provider. Usually, timing is not critical on a refinance.

Even after a loan closes, a borrower refinancing with any lender other than his current lender, has 3 days to rescind it. The lender must then return all fees and remove any liens on their property. This right is not granted to loans used to purchase or construct a house.

The Case For Borrowing to Purchase

Cash-out Refinances Are Priced Higher: One downside of taking the mortgage after you have purchased the house is that the mortgage will then be classified as a "cash-out refinance" as opposed to a "purchase mortgage". Why does that matter? Cash-out refinance loans are viewed as riskier than purchase loans, and therefore are priced higher. On prime loans, the rate difference is about 1/8%. On riskier loans, the difference can be larger.

Only a small proportion of those who take cash-out refinances have houses that don’t already have a mortgage, as in your case. Most have a mortgage and want to raise cash, and some of those are in financial distress and end up in default. That’s why cash-out refinances have higher loss rates than purchase mortgages, and are charged a higher price.
Points Paid on a Cash-out Refinance May Not Be Deductible: On a purchase loan, points are wholly deductible in the transaction year. On a refinance points must be prorated over the term of the loan unless the proceeds are used to improve the house.

Cash-out Refinances Are Not Protected Against Deficiency Judgments: In some states (including California), if a purchase mortgage goes into foreclosure and the property value is not sufficient to make the lender whole, the lender cannot obtain a deficiency judgment that allows it to go after the borrower’s other assets. The borrower has no such protection on a refinance.

Title Insurance Costs Are Higher on a Cash-out Refinance. The borrower purchasing title insurance when buying the property will nonetheless have to buy a policy for the lender when refinancing. Typically, the two policies purchased separately will cost more than two purchased together.

Borrower Loses Lender Protection on a Cash-out Refinance. Having a lender involved in a purchase decision can sometimes save the borrower some grief. An example is the purchaser of a condominium who discovers that the project does not meet the lender’s guidelines for reasons that are as relevant to the buyer as to the lender. For example, too many units in the project remain unsold.

Best of Both Worlds?

I must mention the possibility of getting the best of both worlds, even though I am not yet sure how many borrowers can take advantage of it. Irving Steinman, a mortgage broker in Los Angeles, tells me that he has brokered many “technical refinances” which must occur within 90 days of the purchase. These are viewed as purchase loans by both the lender and IRS. Readers who can provide more information about technical refinances are invited to write me.

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