In most instances, the term "cash-out refinance" describes a type of mortgage refinance on a primary residence. The original loan on the residence is replaced with a new loan with a higher balance. The additional balance is due to funds being pulled from the value of the home, known as cash-out. Borrowers typically use this type of loan to improve the current residence, combine debts or obtain additional cash. For this type of loan, the borrower's residence must be worth more than the current debt owed on the residence, a term often called equity.
The most important factor in a cash-out refinance is the loan-to-value ratio of the borrower's residence. This is an equation that compares the amount of the loan to the appraised value of the home. In order to determine the LTV ratio, the lender adds up all of the debt on the home, typically a first and second mortgage. Next, he gets a professional appraiser to determine the value of the home. The appraiser compares the home to similar ones in the area. He gets an average value based upon comparable sales within the past six months to a year. The lender divides the total loan amount into the appraised value of the home to determine the LTV ratio.
Acceptable LTV Ratios
For conventional mortgages, those underwritten by Freddie Mac and Fannie Mae, a borrower cannot have an LTV ratio higher than 80 percent. This means that the borrower can have a cash-out mortgage amount up to 80 percent of the appraised value of the home. Prior to 2011, a borrower could have a higher LTV with the use of private mortgage insurance.
While the LTV ratio is the most important factor in determining the amount of a cash-out refinance, the debt-to-income ratio is arguably the second-most-important ratio. The lender compares the total monthly debt payments of the borrower to the borrower's pre-tax income. While this ratio varies from lender to lender, most prefer that no more than 43 percent of the borrower's income be dedicated solely to debt repayment. So, if the new cash-out refinance amount ups the borrower's debt-to-income ratio to higher than 43 percent, the borrower will either have to lower the requested cash-out amount or not proceed with the deal.
Keep in mind that lenders use more than just the LTV and DTI ratios as determining factors in loan approval. Additional factors include the condition of the home, credit scores, credit reports and employment history. Prior to refinancing your residence, it is important to check your credit report to ensure that it is correct. Clean up past credit errors and raise your score by resolving judgments, liens and collection actions. Pay down credit card debt to less than 30 percent of your credit limit.
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