125 Percent Refinance May Present Challenges

For homeowners who are "underwater" on their mortgages, the 125 percent refinance option offered under the administration's Making Home Affordable Program may seem like a dream come true. But making that dream a reality could turn out to be a challenge.

In essence, the options allow you to refinance your mortgage for more than your home is currently worth - up to 25 percent more, to be exact. It's designed for homeowners who can't get a regular mortgage refinance because their homes have lost value, leaving them "underwater" on their mortgages.

The 125 percent option is presently available for mortgages backed by Fannie Mae and will be available for Freddie Mac mortgages as of Oct. 1. The FHA has also announced that it will allow 125 percent refinances under its own program, which has different rules from the other two.

Criteria vary by program

To qualify for a 125 percent refinance, homeowners must meet several criteria. First, their mortgage must be backed by Fannie Mae, Freddie Mac or the FHA - which together account for the vast majority of U.S. mortgages. You can check on the Fannie Mae and Freddie Mac web sites to determine if either of them backed your loan; an FHA mortgage would have been designated as such when you took it out.

To obtain a Home Affordable Refinance on a Fannie Mae or Freddie Mac mortgage, you need to apply through a participating lender. It doesn't have to be the same lender that currently services your mortgage, although there'll be less fees and paperwork if you do. On the other hand, your original lender might not wish to refinance - the program is optional - so you might have better luck shopping around.

Can't combine secondary mortgage

You can have some fees, such as for origination and the mortgage application, rolled into the new mortgage, but you can't combine a primary and secondary mortgage into a single loan - the rules prohibit taking cash out of the refinanced mortgage, which also applies to using part of the proceeds to pay off a second lien. If you do have a second mortgage, the holder of that lien will have to agree to resubordinate it, so that the refinanced mortgage gets paid off first in the event of a foreclosure.

The refinanced mortgage must also provide a borrower benefit, which can be a lower interest rate, faster payoff of the mortgage or a lower monthly payment.

Obtaining that borrower benefit might be difficult when refinancing a conventional 30-year loan, because you're going to have to pay a higher interest rate on a 125 percent loan than you would on a 80 percent loan to value refinance - perhaps a lot more, enough so that refinancing is no longer worthwhile. For borrowers looking to get out of a zero-interest loan, option ARM or other "exotic" mortgage, though, the higher rate might make it worthwhile.

Lender participation is key

Another potential obstacle is whether lenders will embrace the 125 percent program. Fannie Mae and Freddie Mac don't actually issue mortgages themselves; they purchase them from lenders who follow their guidelines. However, participation in the program is voluntary and lenders can be choosy about who they decide to help.

Cameron Findlay, chief economist for Lending Tree, said restrictive underwriting standards for high loan-to-value mortgage refinances are leading many lenders to conclude the program just isn't worth the trouble.

"On the 125 percent program, we haven't seen a lot of traction," he said. "I don't think you'll see any improvement until you see some relaxation of the process."

On the other hand, Tom Kelly, a spokesman for JP Morgan Chase, said adjusting to the new guidelines has been relatively straightforward, unlike the delays experienced after the government first announced the Making Home Affordable program last spring.

"We're able to get up to speed faster on it than on the original one, because the mechanics are similar to 80/105," he said, referring to the program's original 80 percent/105 percent refinancing guidelines.

Different program for FHA loans

The FHA's 125 percent refinance program is also new, but works differently from the Fannie Mae and Freddie Mac refinances. On an FHA mortgage, the FHA provides incentives for lenders to break out part of the mortgage principal into a second mortgage, which is tacked onto the end of the first. The primary mortgage is then modified to lower the monthly payments, and the second mortgage only comes due after the first is paid off. It's not yet clear how readily homeowners will be able to participate in the program.