Persfi/27 inches/LK1st/mark2nd
KENNETH R. HARNEY (MUG ON FILE)
For thousands of American homeowners, the question of the week is not whether to refinance their mortgage, but whether to pull extra cash out when they do refinance.
Put another way: Mortgage-rate decreases since the summer have rendered the refi question a no-brainer for lots of people. If you can cut your fixed mortgage rate from the mid- or upper-7 percent range to the mid-6’s at a cost you can recoup in 12 to 18 months, then the answer is almost always yes to a refi.
But what happens to the equation when you like many other homeowners are tempted to take out extra money, beyond your current total mortgage debt, to use for some non-housing purpose?
Say you have a $200,000 home with an existing $140,000 first mortgage at 8 percent. You know you can save a bundle by refinancing into a new 30-year $140,000 mortgage at 6.75 percent.
But what if you want to pull more cash out of the transaction say another $20,000 to $30,000 to help pay for the kids’ tuition, or to invest, or to buy a new car? Are you going to have to pay more? The answer is not so simple.
The automated underwriting systems widely in use and connected to mortgage-industry giants Fannie Mae and Freddie Mac will evaluate, and price, you differently when you want to pull extra cash out. Ditto for most large mortgage companies that sell their loans into pools that become bonds on Wall Street.
But some lenders won’t charge you extra, or hold it against you, if you want some more cash in your pocket. Here’s a quick overview of what to expect in the little-charted financial territory known as “cash-out refi’s.”
Both Fannie Mae and Freddie Mac are happy to buy mortgages involving cash-out refinances. But executives at both companies say that cashing out increases your statistical probability of default down the road. As a result, you may have to pay a bit more on the rate from the lender who sells your loan to either Fannie or Freddie.
For both companies, a key factor is your “loan-to-value” ratio, or LTV. Once you push your LTV over 75 percent through a cash-out, you likely will be asked to pay a premium on your rate. How much of a premium depends on contractual arrangements with individual lenders and on your overall risk profile, according to both companies. But mortgage-industry sources say one-quarter of 1 percent extra on the rate would be a typical surcharge.
In the $200,000 example above, once you took your loan above $150,000 (75 percent LTV) to $160,000 (80 percent LTV), you’d probably trigger an extra quarter of a percentage point on the rate. Instead of a 6.75 percent quote from your lender, in other words, you’d get 7 percent.
The rationale? According to Fannie Mae Vice President Frank DeMarais, “It’s a fairly well-documented risk factor” that when people pull out mortgage cash for non-mortgage purposes, the likelihood of default increases.
Freddie Mac’s automated underwriting system approaches cash-out refi’s much the same as Fannie’s. But Freddie Mac spokeswoman Sharon McHale emphasized that the electronic system’s complex evaluations of each loan application “could very well” end up charging a borrower little or nothing extra for a modest cash-out above the 75 percent LTV guideline. People with particularly high credit scores, for example, might pay zero extra on a cash-out, said McHale.
Should you take cash out when you refi? If your LTV and credit scores qualify you for cash-out at a low premium, and you have a good use for the money like paying down high-rate consumer debt why not?
Tax breaks for home-sellers
Just in case you thought the federal tax laws couldn’t get any more favorable to homeowners after two major reform bills in less than two years, think again.
Tax specialists on Capitol Hill say many taxpayers have overlooked key “effective date” provisions hidden in the fine print of the 1997 and 1998 tax laws that bestow even more goodies on certain sellers of homes. The provisions could be especially helpful to people who want to sell their home tax-free in the coming months, but don’t think they qualify under the 1997 and 1998 tax laws’ strict two-year minimum ownership rules on capital gains.
Congress substantially liberalized federal tax treatment of most home sales in the 1997 Taxpayer Relief Act. Under that law, individual home sellers are permitted to keep up to $250,000 in capital gains ($500,000 for married sellers who file taxes jointly) on sales of houses they’ve used as a principal residence for two of the prior five years.
Congress sweetened the deal even further in the 1998 Internal Revenue Service Restructuring and Reform Act, signed into law this summer. This year’s change cleared up an issue left fuzzy by the 1997 law: the tax treatment of people who sell for a gain in less than the two-year minimum. The 1997 law had said that such taxpayers could take a pro-rata approach to shielding their gains from taxation. If you owned and occupied your principal residence for 18 months and sold it, for example, you could pocket 18/24ths (three-quarters) of the gain you’d pocket if you lived in the house for a full two years.
The 1998 law clarified that the maximum gain you could multiply that residency fraction against is the full $250,000/$500,000 statutory amount, not your actual dollar gain on the sale. That’s a potentially big money-saver for the thousands of Americans every year who get transferred, or are forced to sell because of illness, after living in their home for less than two years.
But what about people who don’t qualify on the employment or health tests, but simply want to sell after owning for less than two years? Do they have to pay capital gains taxes on their profits after the sale?
Here’s the good news, at least for some of them: Anyone who owned his or her home as of Aug. 5, 1997, and now wants to sell it, can do so and reap the full tax-saving benefits of the 1998 law without meeting the employment, health, or “unforeseen circumstances” tests. They must, however, meet the “principal residence” and use requirement, and they must close their sale before Aug. 6, 1999.
To illustrate how this works in real life, take the case of a couple who bought their home in July 1997. Now they’d like to move to a different neighborhood in order to send their kids to better schools. Thanks to their strong local real estate market, their house has racked up a $50,000-$60,000 gain since they’ve owned it. They don’t qualify for the capital gains exclusion for employment or health reasons, and they are reluctant to take a chance on arguing to IRS auditors that their kids’ school situation constitutes an “unforeseen circumstance.” So they assume that if they sell this fall, they’ll have to pay taxes on their full gain.
But they’re in luck. Under the “effective date” loophole, they call sell without worrying about meeting the standard test as long as they conclude the deal by next Aug. 5.
Kenneth R. Harney is a nationally syndicated columnist who writes on real estate and personal finance. Jane Bryant Quinn is on vacation.
