Underwater? Weigh These Refinancing Options

Dear Dr. Don, I currently have a 7/1 ARM at 6.125% with a local credit union. I'd like to trim my current fixed expenses. With many everyday costs going up and another baby on the way, we need more cash at the end of each month to cover new expenses with a new member in the family and our first child beginning school. Refinancing could provide us more than $600 per month to cover these new expenses.

Currently our mortgage is $495,000. Our appraised value has been significantly affected by the comparable homes in the area due to short sales and bank-owned properties. Without a formal appraisal, our broker estimates our home will appraise around $460,000 based on recent activity in the neighborhood.

  1. Are there any loan programs that could approve a loan amount of 110% loan-to-value? I'm aware of the Fannie and Freddie refinancing programs, but they don't apply to our current loan, which is a jumbo loan.
  2. If not, what are the rules around hardship claims to use funds from my individual retirement account to bring my loan out of being upside down?

I've read through the details of several programs, and usually I don't qualify because of the home's declining appraised value. Foreclosures and short sales in the neighborhood haven't helped. Neither has my monthly debt-to-income ratio. I would think refinancing, by improving my loan ratios, would make me a better borrower in the eyes of the lender. Your advice is much appreciated. -- Ramsey Refinance

Dear Ramsey, First to clarify for our readers, a home is underwater when its mortgage is greater than its appraised value.

In that situation, a lender will consider how the refinancing changes your front-end and back-end debt ratios. The front ratio looks at principal, interest, taxes and insurance, or PITI, as a percentage of your gross monthly income. The back ratio adds any other loan commitments to the housing expense and measures that as a percentage of your gross monthly income. Historically, conventional lenders wanted front ratios to be at or below 28% and back ratios to be at or less than 36%. Federal Housing Administration and Veterans Affairs loans allow higher ratios in qualifying borrowers.

The federal government has revised its Home Affordable Refinance Program, or HARP. The key revision that may apply to you is the increase in how far you can be underwater on your mortgage while still qualifying for the program.

As you point out, the stumbling block for you to qualify for this program is that your mortgage needs to be a conforming loan. Conforming loan limits vary by county from $417,000 to $625,500 for a single-family home. The higher limit is for homes in high cost-of-living areas.

If you tap your IRA to bring cash to closing, you would make the refinanced mortgage once again less than the home's appraised value. IRAs don't have the same hardship provisions that may be available in a 401(k) plan, though certain early distributions out of??an IRA are exempt from the additional tax on early distributions. Tapping your IRA balances to do a cash-in refinancing isn't going to meet any of the exemptions for the penalty tax in your situation.

Sure, you can bring cash to closing from your IRA to qualify for a conforming loan, and you won't need the HARP program to refinance. But it's not going to be considered a hardship distribution. Distributions are taxable in the year taken, and it's likely you will owe an additional 10% penalty tax on the early distribution. You'll have to raid the account for a lot more than the $78,000 difference between your mortgage loan balance and the $417,000 conforming loan limit to cover the taxes and penalties. Since this will be a 90% loan-to-value mortgage, you'll pay private mortgage insurance, or PMI, on the loan, which will reduce the monthly savings on the mortgage payment.

Getting a new nonconforming (jumbo) mortgage with a 90% loan-to-value would have you raiding the IRA account for every bit as much money as getting a conforming mortgage. So, you might as well get a conforming loan and capture the lower interest rate available on such a loan.

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