Divorce and the Family Home: Option Two – A Cash-Out Refinance
This article is part of a 5-part series on what divorcing couples might do when faced with the pressing question of what to do with the family home.
This second option – a cash-out refinance – can make sense if one spouse wants to stay in the home, and the other is fine to cash out and leave.
What is a cash-out refinance?
With a cash out refinance, you essentially take on a new mortgage that will pay off your existing mortgage and also pay out your spouse’s equity share in the house. It is a new loan that is subject to the current mortgage interest rates.
To give an example, let’s say, for instance, that you owe $100,000 on your mortgage. And your house is appraised at $300,000. In this case, you and your soon-to-be-ex would have $200,000 of home equity – presumably $100,000 each. If you are the spouse remaining in the home, you would refinance into a new mortgage for $200,000. With this new loan, you would pay off the existing loan balance ($100k) as well as pay out your departing spouse’s equity share ($100k). As the remaining spouse, you keep both the home and its future value. The departing spouse would walk away with cash.
Before we look into a refinance, can’t we avoid all this by simply transferring the deed?
The short answer to this question is: “No, unfortunately not.” If you are co-signed on a mortgage with your soon-to-be ex-spouse, then you cannot simply retitle the house as a way to transfer the mortgage. Signing a quit claim deed does not remove you, or your spouse, from the mortgage. In the eyes of the lender, you are still on the hook – even if you have retitled the property.
What are the benefits of a cash-out refinance?
A cash-out refinance can be a great option if it is feasible and meets the objectives for both you and your soon-to-be ex-spouse. If you are clear that one of you wants to remain in the home, and the other one wants to leave, then it is sensible to explore whether a refinance is possible.
A cash-out refinance can also be a great option because it offers a clean break and certainty. The spouse that remains in the home is offered an opportunity to keep a home that they want to be in. Perhaps the home carries with it a sense of stability? Or you think it’s a great home and investment that would be difficult to replace? Or it may be in a good school district so your children’s schedules are undisturbed.
And for the departing spouse, they get a fresh start. The mortgage is taken off their credit report – they are not encumbered by a joint debt. And they may receive an influx of cash to look for a new home.
What are the downsides to a cash-out refinance?
The most notable downside of a cash-out refinance is, not surprisingly, rising interest rates. If you refinance today, you may be incurring a loan with a much higher interest rate; and, consequently, an increased monthly mortgage payment. This particular trend of rising rates is creating complications for divorcing couples all throughout the country.
There is also the issue of costs. It may cost 2-6% of the home loan to complete the refinance. You should check with your bank to see whether some or all of these costs can be wrapped into the mortgage. You should also be aware that a refinance takes time – often about 6 weeks to complete.
Finally, for the remaining spouse, there is the issue of affordability. If you secure a refinance, can you afford the new mortgage on one salary? And can you also cover the costs of home ownership on one salary? It is important that you spend time creating a budget so you have a complete financial understanding that compares your income against your anticipated costs.
Can I qualify for a refinance?
Qualifying for a refinance is often the most pressing question for homeowners. It boils down to the three “C’s” – capacity, credit and collateral.
Capacity relates to your debt-to-income (DTI) ratio. Banks will want to review your financial situation to understand whether you have enough income to cover your monthly expenses by a certain percentage. The bank will investigate your “front-end DTI“ with analysis of your house-related expenses; as well as your “bank-end DTI” with analysis of your non-house minimum required monthly payments (e.g., a car payment or student loan). A bank will divide your monthly payments by your gross monthly income, and then convert that result to a percentage. A conventional home loan will require a stricter ratio of debt-to-income; a Federal Housing Administration (FHA) loan will be more lenient.
Credit relates to your credit score — many lenders want to see credit score of at least 620 to refinance to a conventional loan. Most FHA lenders require less – more in the ballpark of mid-500s.
Collateral refers to the home securing the loan and its loan-to-value (LTV) limit. A LTV ratio is a measure between the amount left on your mortgage and the value of your home. If your LTV is 80%, for example, that means you own 20% of your home. Essentially, the bank wants assurance that you have enough equity in your home.
Will child support or spousal support payments count as qualifying income?
When a bank looks at your debt-to-income ratio to see whether you have enough income to cover a new loan, they may take into consideration your receipt of child support and/or spousal support. These support payments often boost your qualifying income if it is considered “stable” income. To this end, many banks will want to see that you’ve received child and/or spousal support payments for at least 6 months prior to applying for a conventional loan. The time limit is often shorter (for example, 3 months) for an FHA or VA loan. In all cases, you should speak with your bank to see what is required.
Do I necessarily have to borrow to “cash out” my departing ex-spouse?
No, if you have other assets to swap, you do not necessarily have to borrow cash to pay off your ex’s equity share. You may, for instance, consider apportioning a greater percentage of your joint retirement savings or brokerage account to your ex as consideration for their equity stake in the home. If this is possible and you reach agreement, then you only need to refinance the amount remaining on your mortgage. However, with this option, you should consider the tax implications of the various assets you are trading.
What if my application to refinance is denied?
If your attempt to refinance is denied, you should speak with the bank to understand why your application failed. If, for example, your DTI ratio is an issue, you may be able to pay down certain non-mortgage debt to fall within an approved range. Bank applications can be a slog, but persistence is often rewarded.
You could also wait to refinance so as to allow time for your home to increase in value, your credit score to increase, your mortgage balance to reduce, and/or interest rates to go down. There are, of course risks – interest rates could go up further. And as long as both you and your ex-spouse are co-signed on the mortgage, any missed payments will negatively impact your credit score.
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If you have questions about whether what to do with your family home during divorce, contact Jim Robenalt, an experienced mediator and lawyer, to discuss your particular circumstances. To schedule a free consultation call, you can get in touch with Jim by calling.