More than a decade removed from the financial and housing crisis of 2008, there remains a good deal of debate on its cause. Data most often compare the default and loss behaviors of conventional loans and rate refinancing during this time.
But dig deeper and there’s another factor involved — and it’s a big one.
Overall, the poor performance of cash-out refinancing, and loan refinancing in general, has been viewed as an important contributing factor. That point was raised in The Journal of Fixed Income Summer 2018, and cash-out refinance remains under the microscope to this day.
Cash Out Refinance Before the Housing Crisis
The National Bureau of Economic Research said rising home prices and falling mortgage rates enhanced the allure of refinancing for millions of homeowners before 2008. At the same time, lenders weren’t just pushing a new, fixed-rate loan. They were also pushing homeowners to extract equity with a cash-out refinance, “increasing systemic risk” in the financial system.
We all know what happened after that. But how many of us know what the refinance equity requirements were like more than a decade ago when compared to those same requirements today?
To understand, you really need to focus on the loan-to-value ratio.
Understanding Loan-to-Value Ratio in a Cash Out Refinance
The loan-to-value ratio of a mortgage is one of the most important numbers in the entire transaction. Commonly called the LTV, it’s a number the lender will use to determine how much of a risk they’re taking on your secured loan.
Above all, the LTV also measures the relationship between your loan amount and the market value of your home.
If the lender offers a loan worth three-quarters of the value of your home, for example, the LTV would be 75%. As the LTV increases, the lender is facing a much higher risk if you fail to repay the loan.
According to Investopedia, an LTV of 80% or lower is considered good for a mortgage and provides the best chance of being approved, along with a better interest rate.
So, how does this equate with cash-out refinance equity requirements?
Cash Out Refinance Then …
A cash-out refinance is just one of the ways homeowners can take advantage of the equity (or the difference between the current value of a property and the amount owed on the mortgage) in their homes. But it was easier to get approved before 2008, and walk away with more money. That’s because the Federal Housing Administration (FHA), which is part of the Department of Housing and Urban Development (or HUD), insured loans that exposed the government to potential defaults.
How? The FHA allowed homeowners to cash-out up to 95% of their home’s value at the time and had much less stringent underwriting requirements.
MarketWatch reported that the peak of cash-out refinancing came in 2005-06, as millions of American homeowners attempted to make a cash grab out of their home equity. According to Attom Data, some 16 million mortgages were refinanced in that time frame, and the dollar amount was stunning, sitting at $1.8 trillion.
In total, the same data sets show that $3.1 trillion in cash-out refinancing was approved for homeowners between 2005 and 2007 just before the housing crisis erupted.
And Cash Out Refinance Now
In 2009, the FHA adjusted its limit for borrowers to reduce the prevalence of cash-out refinancing. It did so again in September 2019.
The latest modifications mean that FHA borrowers are now limited to a cash-out refinance loan-to-value ratio of 80%, meaning borrowers need to maintain at least 20% equity in the property based on a new appraisal. (In other words, on a home valued at $300,000, the maximum loan amount would be $240,000).
According to Lending Tree, there are also other guidelines to qualify for an FHA cash-out refinance. They include:
- Providing proof that the property is your primary residence
- Providing proof that you’ve lived in the home at least a year
- Providing proof that all mortgage payments have been made on time
- Having a minimum credit score of 580 (or, if have at least 10% equity in your home, your credit score can be as low as 500)
- Having an overall debt-to-income ratio of 50% or less
Additionally, there are other FHA refinance limits that borrowers must adhere to.
How Other Cash Out Refis Compare
The FHA’s 80% loan-to-value ratio put it in line with the rules established by both Freddie Mac (the Federal Home Loan Mortgage Corporation) and Fannie Mae (the Federal National Mortgage Association) for cash-out refinancing.
Fannie Mae’s tighter cash-out refi guidelines and equity requirements are detailed in the comprehensive ‘Eligibility Matrix’, a system allowing lenders to quickly determine if you qualify for a mortgage based on the information you provide.
One of the things you should be aware of is the focus on debt-to-income cash-out refinances. If you’re applying for a Fannie Mae loan with a DTI of higher than 45%, you’ll need to prove you have the ability to cover at least six months of mortgage payments (commonly known as reserves). For example, say your monthly mortgage payment was $1,200, a common figure used by the Eligibility Matrix. You would be required to prove you have available assets totaling at least $7,200, which could be used to make a mortgage payment in the event of short-term income loss or another scenario impacting your finances.
Freddie Mac has comparable cash-out refinance guidelines, all meant to be prudent measures to protect both lenders and borrowers. Overall, the analysis of a borrower’s stable monthly income is considered integral to the overall qualification and ability to repay the mortgage along with other monthly bills.
For VA (military) borrowers, most lenders will cap the maximum loan amount to 90 percent of home value, regardless of any VA limit.
Finally, some borrowers might opt for a conventional cash-out refinance (or a non-government backed loan). Anyone with at least a 620 credit score and DTI below 50% stands to qualify, but generally, the 80% LTV ratio/20% equity rule applies.
A Final Word on Cash Out Refinance
As The Washington Post reports, cash-out refinancing has once again become incredibly popular, buoyed by rising home values and falling mortgage rates. In fact, the newspaper says FHA-cash out refinances increased by 250% between 2013 and 2018.
While a cash-out refinance allows you to access a large sum of money without selling your home, it won’t let you avoid closing costs, which will be similar to those tacked on to your original mortgage (usually 2 to 5% of the home’s purchase price).
If you can accept a limit on the amount of money you can borrow and you understand that the interest rate for your cash-out refi will likely be higher than your original mortgage, this type of loan might be worth looking into. Just remember — a cash-out refinance replaces your current mortgage with a new loan for more than what you owe. That means cash-out refinance equity requirements are largely for your own good, to ensure you still have some equity in your home.
- What Fueled the Financial Crisis? An Analysis of the Performance of Purchase and Refinance Loans, The Journal of Fixed Income (Summer 2018). Accessed from https://jfi.pm-research.com/content/28/1/27.short
- The Refinancing Boom and the Financial Crisis, The National Bureau of Economic Research. Accessed from https://www.nber.org/digest/dec09/w15362.html
- Loan-to-Value Ratio Definition, Investopedia. Accessed from https://www.investopedia.com/terms/l/loantovalue.asp
- This Home Mortgage Disaster is Ready to Punish Housing Markets, MarketWatch. Accessed from https://www.marketwatch.com/story/this-home-mortgage-disaster-is-ready-to-punish-housing-markets-2019-11-19
- Understanding FHA Cash-Out Refinance Loans, Lending Tree. Accessed from https://www.lendingtree.com/home/refinance/fha-cash-out-refinance/
- Single Family Selling Guide, Fannie Mae. Accessed from https://selling-guide.fanniemae.com/Selling-Guide/Origination-thru-Closing/Subpart-B2-Eligibility/Chapter-B2-1-Mortgage-Eligibility/Section-B2-1-3-Loan-Purpose/1736853471/B2-1-3-03-Cash-Out-Refinance-Transactions-07-03-2019.htm
- Inside the VA Cash-Out Refinance, Military.com. Accessed at https://www.military.com/money/va-loans/cash-out-refinance/inside-the-va-cash-out-refinance.html
- FHA sets limits on cash-out refinancing, The Washington Post. Accessed from https://www.washingtonpost.com/business/2019/08/27/fha-sets-limits-cash-out-refinancing/