June 9, 2003, revised August 20, 2003, December 1, 2006"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?"

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 non-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.

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

*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 it is not used to pay off an existing mortgage, 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 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. Under the agencies' rule, refinancing your second mortgage will forever be cash-out.

The One-Year Rule

The one-year rule you were cited must have come from portfolio lenders -- those who originate loans to hold rather than to sell in the secondary market. This rule says that after a second mortgage is on the books for a year, it is no longer an indicator of additional risk, provided you don't take any cash out.

You might want to go back to these lenders after a year elapses, when they will no longer view your loan as cash-out. The more numerous lenders who sell in the secondary market will continue to view your deal as cash-out.