Why Is This Mortgage Refinance "Cash-Out"?

June 9, 2003, revised August 20, 2003, December 1, 2006, Reviewed October 31, 2010

"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?"

Your second mortgage must have been taken out after the first mortgage, rather than being part of the home purchase transaction, and that made you vulnerable to the 12 month rule. The rule is that any refinance that occurs within 12 months of a cash-out refinance, or within 12 months of a second mortgage that was not part of the home purchase transaction, is considered cash-out, whether you actually withdraw any cash or not. A cash-out refinance is considered riskier than a no-cash refinance, and you have no recourse but to wait.

Why Cash-Out Refinance Is Considered Riskier

Studies of delinquency and default indicate that borrowers who do a cash-out refinance 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.

How "cash-out" was defined in these studies, however, is not clear. The lay definition of a cash-out refinance is that the new loan balance exceeds the old one, but whether the transaction increases risk would appear to depend on the use made of the funds. As soon as usage enters the picture, complications mount.

The Agencies' Definition of "Cash-Out"

The most widely used definition is that of the two Federal secondary market agencies, Fannie Mae and Freddie Mac. Their rules define a cash-out refinance by exclusion, i.e., they define an ordinary or no-cash-out refinance, and any refinance that does not meet that definition is considered cash-out.

A no-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. A no-cash-out refinance can also be one that retires a previous refinance, including a cash-out refinance that occurred at least 12 months earlier, subject to the same limitation on the excess of the new loan amount over the existing balance.

Under this definition, the following types of transactions are cash-out.

*A new mortgage for an amount larger than the existing balance by an  amount larger than 2% of the new loan amount or $2,000, whichever is less.

*A new mortgage on a property previously held free and clear. Since it is not a purchase mortgage, it must be a refinance, and since the amount exceeds the existing mortgage balance, which is zero, it must be a cash-out refinance.

*A new mortgage used to pay off an existing mortgage where the cash taken out, which exceeds the agency limits, will be used to improve the property.

*A new mortgage used to pay off a second mortgage that is less than 12 months old and was not used in purchasing the property.

The last is your case. Because your second mortgage was not used to acquire your home, refinancing it would be considered a cash-out transaction. The rationale is presumably that you needed cash when you took the second mortgage, and if you were in financial distress then, perhaps you still are.

A New Wrinkle

In 2010, the agencies tightened the screws on refinancing HELOCs. If the HELOC was part of the purchase transaction, either as a first or second mortgage, and the borrower drew on the HELOC after the purchase, the new loan is cash-out, 

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