Homeowners who need to refinance an existing mortgage, but don't have substantial equity, might want to act soon to avoid a new rule that could make refinancing more expensive. However, the rule governing "qualified residential mortgages" is still in flux and won't be in effect until at least a year from now.

At issue is the so-called credit risk retention rule, which is part of the federal Dodd-Frank Act. The rule "requires lenders that securitize mortgages to retain 5 percent of the credit risk, unless the mortgage is a qualified residential mortgage or otherwise exempt," according to the National Association of Realtors.

Six federal agencies have proposed a joint definition of the qualified residential mortgages, or "QRMs." These loans are expected to be less costly for borrowers because the loans won't be subject to the risk retention requirement.

Equity required to refinance

The proposed QRM definition would require homeowners to have at least 25 percent equity for a rate-and-term refinance or at least 30 percent equity for a cash-out refinance, and it would require them to meet other credit-related guidelines as well. By some estimates, fewer than half of the homeowners in the country have that much equity.

The result, says Kathleen Day, a spokeswoman for the Center for Responsible Lending, an advocacy organization in Washington, D.C., would be less opportunity for homeowners to refinance.

"They may be stuck in a high-cost mortgage, even (though) the rates are down because the law says they're a risk, even though they're not," she says.

States that have large numbers or substantial percentages of equity-poor homeowners include: Arizona, California, Colorado, Florida, Georgia, Idaho, Illinois, Michigan, Mississippi, Nevada, North Carolina, Ohio, Texas and Utah. That's according to an analysis of CoreLogic data published in a white paper from the Coalition for Sensible Housing Policy, a group of real estate trade associations, consumer organizations and civil rights groups lobbying for a less strict QRM definition.

QRM alternatives

Equity-poor homeowners who need to refinance might want to act before the credit risk retention rule becomes effective, says Ken Dickson, senior vice president of Johnson Bank in Madison, Wis.

"If you're a homeowner today and need to refinance," he says, "the time to do it is now."
Then again, Dickson says, the QRM rule hasn't yet been finalized, which suggests the rush might turn out to be unnecessary.

"'It's not yet finalized' is probably the most important thing I can tell you," Dickson says.

Homeowners also may have other options to refinance, even if the rule takes effect as proposed.
One option might be a loan insured by the Federal Housing Administration because, as proposed, the rule would exclude FHA loans. Today, these loans don't require much equity to refinance. However, borrowers must pay for mortgage insurance and, as Dickson says, the maximum loan sizes in high-cost areas are set to drop Sept. 30.

Another option might be a conforming loan, which lenders can sell to Fannie Mae or Freddie Mac. The proposed rule allows conforming loans to avoid the risk retention requirement, but only as long as Fannie Mae and Freddie Mac continue to operate under federal government conservatorship. Should these entities be privatized, an eventuality that has some support in Washington, D.C., conforming loans might not be an option for equity-poor homeowners.

A third possibility might be a loan that has mortgage insurance. As proposed, the rule doesn't say whether these loans will be excluded from the risk retention requirement. That's because the six federal agencies are sorting through the hundreds of comment letters they received during the period that ended Aug. 1. Mortgage insurance more than likely will be addressed in the final rule.
Yet another option for homeowners would be to bring cash to closing in what's known as a cash-in refinance. This strategy lowers the homeowner's outstanding loan balance, boosting the equity ratio to meet the requirement. Again, there's a downside: Dickson says mortgage closing costs are more expensive today, which means borrowers have less cash to contribute for the equity boost.
HARP to sunset
Astute homeowners might wonder how the QRM definition will affect the Home Affordable Refinance Program, or HARP. This program enables homeowners to refinance up to 125 percent of their home's value. To qualify, homeowners have to owe more than the home is worth, be current on their mortgage and have a loan that's owned or backed by Fannie Mae or Freddie Mac.
How QRM and HARP would coexist is an intriguing question, but probably moot since HARP is set to sunset June 30, 2012. That means unless HARP is extended, it will end before the risk retention rule gets a chance to kill it.