Refinancing a mortgage? Fannie Mae tightens guidelines (again)

If you want to refinance a home, and prefer adjustable rate mortgages or interest-only loans, you may want to apply before mid-June. Not only are today's mortgage refinance rates very low, but these products will soon be harder to get.

Qualifying for ARM refinancing and hybrid ARM gets tougher

For Fannie Mae loans electronically underwritten (most loans), if submitted after the weekend of June 19, 2010, qualifying will be a bit different (manually-underwritten loan guidelines will change Aug. 1, 2010). Currently, if you choose an ARM that adjusts in one year or less, you qualify at either the start rate (for ARMs with adjustments capped at 1 percent or less) or the start rate plus the maximum adjustment for the first year (for ARMs with adjustments capped at more than 1 percent).

So, if you have a 1-year ARM with a 2-percent adjustment cap and a 3-percent start rate, you'd qualify at 5 percent (the start rate plus the maximum 2 percent adjustment). If it has a 1-percent cap, you'd qualify at the start rate of 3 percent. Under the new rule, you'd qualify at the higher of the fully-indexed rate (the rate that your ARM would adjust to if it adjusted today) or your start rate plus two percent.

The loan that this change really makes a huge difference for is the popular 5/1 hybrid, also called a 5-year ARM. Currently, you'd qualify at the start rate, which would be your interest rate for the next 5 years. But under the new rules, you'd qualify at the higher of the fully-indexed rate or the start rate plus 2 percent. Today, you can get a 5/1 refinance mortgage at about 4 percent, and you'd qualify at that rate. But under the changed guidelines, you'd qualify at about 6 percent (2 percent higher).

How does this affect your actual home loan refinance approval?

Assuming that your mortgage payment needs to be no more than 28 percent of your income, that your taxes and insurance are $500 a month, and that the mortgage refinance is $300,000, under the current guidelines, you'd need to earn $6,900 a month to qualify for your loan ($1,432 payment + $500 taxes and insurance / 0.28). Under the new guidelines, you'd have to earn $8,211 ($1,799 + 500 / 0.28).

Interest-only mortgage refinance? Forget about it!

Fannie Mae wants to be very sure that if you choose an interest-only home loan, it's for the purpose of managing cash flow; for example, you'd rather put the extra money into your business or investments rather than your mortgage. Interest-only mortgages for the purpose of affording a more expensive house will no longer be approved.

If you want an interest-only mortgage refinance, you'll need a credit score of at least 720. You won't be able to finance investment properties or multi-unit dwellings this way, you won't be able to get a cash-out refinance mortgage, and (here's the deal-killer!) you'll have to have at least 2 years of reserves. That means you have to document that you possess liquid funds sufficient to make your mortgage payment for at least 2 years in order to be eligible for an interest-only loan.

Who will this hurt? Borrowers who need a lower payment to buy a home but who are reasonably certain of future income or assets to afford a higher payment: for example, recent grads of medical, legal, engineering, or other high-paying degree programs, people who have been awarded legal settlements but won't receive the money for a year or two, those coming into trust funds or inheritances, and home buyers who have non-liquid assets like businesses or property for sale.

With interest-only features, these folks could purchase bigger homes now, then make the higher payment when they have the means to do so. Otherwise, they have to go with the starter home until they are established, then incur the hassle and expense of selling it, buying the bigger home and moving.

Popping the balloon: goodbye 7/23

Finally, the 7/23, also called the 7-year balloon mortgage, will be discontinued. This mortgage has been less popular recently because its rate was about the same as that of the 30-year fixed-rate mortgage, but when mortgage rates increase, the balloon mortgage soars in popularity.

The loan features an interest rate that is fixed for 7 years, then resets and is fixed for the remaining 23 years of its term. The product's retirement has little effect on mortgage refinancing today, but it will likely be missed when interest rates increase to historically normal levels.

The upshot of these changes is that homeowners who want to refinance a mortgage should probably act now. In today's mortgage environment, change is the norm, and revisions to underwriting and pricing are not generally favorable to borrowers.