Type 1 vs Type 2 Cash-Out Refinance

Cash-out refinances can be a great option to change loan terms and pull money out of your home. However, for borrowers considering the VA cash-out refinance program, it’s important to understand some key differences between different loan types. As such, we’ll use this article to explain the VA’s type 1 vs type 2 cash-out refinance.

Specifically, we’ll discuss the following:

• What Is a Cash-out Refinance?
• Overview of the VA Cash-out Refinance Program
• Type 1 Cash-out Refinance
• Type 2 Cash-out Refinance
• Applying for a VA Cash-out Refinance Loan
• Final Thoughts

What Is a Cash-out Refinance?

As the name suggests, a cash-out refinance allows borrowers to take out a new mortgage, pocketing the difference between the new and old loans as cash. More precisely, the new loan pays off the balance of the current mortgage. The remaining balance of the new mortgage then goes to the borrower as cash.

The cash-out loan process hinges on the concept of equity. A borrower’s equity – or ownership – in a home equals the current home value minus the outstanding mortgage. For example, if your home is worth $400,000 and you have a $250,000 mortgage, you have $150,000 in equity ($400,000 value – $250,000 mortgage). Cash-out refinances allow you to convert this equity into cash. And, lenders issue these loans based on three related factors: 1) current home value; 2) outstanding mortgage; 3) loan-to-value (LTV) ratio.

Assume a lender offers a cash-out refinance up to 90% LTV. Using the above numbers, that means the borrower would qualify for a $360,000 cash-out refinance loan ($400,000 value x 90% LTV). However, before paying out cash, the lender must pay off the outstanding mortgage balance. This means the borrower could receive $110,000 in cash from this property – excluding closing costs ($360,000 cash-out refinance loan maximum – $250,000 current mortgage balance).

Why Do a Cash-Out Refinance?

While not all-inclusive, here are some common reasons why people would want to take cash out of their homes via a loan refinance:

• Consolidate debt: If you have thousands of dollars in debt – or more – on credit cards, student loans, or auto loans, you’re likely paying far higher rates than you would on a home mortgage. As a result, many people take the money from a cash-out refinance to pay off other, higher interest debt. This A) reduces interest payments, and B) consolidates debt into a single mortgage payment – administratively easier.
• Finance a large purchase: If you want to add a living room to your house or put together a down payment for an investment property, you may not have enough cash on-hand. A cash-out refinance provides a means to access money at a low rate and long repayment period to use for these large purchases.
• Pay for a financial emergency: Unfortunately, medical, legal, business, and family emergencies can come out of nowhere. And, most of these emergencies also come with large bills. Rather than dipping into retirement savings or maxing out a credit card, a cash-out refinance can provide you the cash you need to address these financial emergencies.

Overview of the VA Cash-out Refinance Program

While most borrowers researching a VA cash-out refinance inherently understand how VA loans work, this isn’t always the case. More precisely, the VA cash-out refinance program is the only program that allows eligible veterans with a conventional mortgage to refinance that mortgage into the VA program. As a result, some veterans considering this refinance program may have never used a VA loan before, so we’ll begin with a brief overview of how VA loans work.

The Department of Veterans Affairs doesn’t actually lend money to borrowers. Instead, the VA guarantees a portion of home loans made by VA-approved lenders (e.g. banks and credit unions). This guarantee reduces risk for lenders, which means they can provide veterans the following favorable terms:

• No down payment
• Low interest rates
• No personal mortgage insurance (PMI) requirement

With these compelling terms, many veterans with an existing mortgage decide to use a VA cash-out refinance. This program allows eligible veterans to replace their current conventional or VA loans with a new VA loan under different terms (rate and repayment period). And, if you have equity in your home, the VA cash-out refinance, as the name suggests, allows you to refinance into a larger loan, pocketing the difference as cash.

While every lender offers different terms, many VA-approved lenders will allow veterans to borrow up to 100% of their home’s value on this refinance – not just on the original VA loan. According to VA guidance, without a down payment, you can borrow up to the Fannie Mae/Freddie Mac conforming loan limits for your area.

Net Tangible Benefit Considerations

With all of its loan products, the VA wants to keep borrowers’ financial interests in mind. As a result, all VA cash-out refinance options require a net tangible benefit test. This test simply asks, will your cash-out refinance loan provide you some financial benefit? If the new loan meets one of the following criteria, it passes the net tangible benefit test:

• Eliminates monthly mortgage insurance
• Shorter loan term than the loan being refinanced
• Lower interest rate than the old loan’s rate
• Lower monthly principal and interest payments than the old loan’s payments
• Leads to an increase in the borrower’s monthly residual income
• Refinancing an adjustable-rate mortgage into a fixed rate
• Loan-to-value ratio of the new loan is 90 percent or less
• Pays off a construction loan

Seasoning Considerations

Additionally, certain VA cash-out refinance loans have a seasoning requirement. This basically means that homeowners must have held a mortgage for a certain amount of time before they qualify for a cash-out refinance. According to the VA, all cash-out refinances paying off an existing VA loan require a seasoning period of 210 days. These days are calculated from the closing date of the original VA loan to the closing date of the new VA cash-out refinance.

Type 1 and Type 2 Cash-out Refinances

Currently, the VA offers two different types of cash-out refinance: type 1 and type 2. We will outline the unique considerations to both loans in the next two sections.

Type 1 Cash-out Refinance

A type 1 cash-out refinance occurs when the loan amount of the new loan is less than or equal to 100 percent of the payoff amount of the loan being refinanced. Generally speaking, this doesn’t qualify as a cash-out refinance, as the borrower does not take out a larger loan and pocket the difference as cash. However, according to VA guidelines and naming conventions, this type of refinance does qualify as a cash-out refinance.

Requirements for Type 1 VA to VA Refinance

• Seasoning certification
• Fee recoupment period certification

NOTE: This means that the borrower must recoup all costs/fees of the new loan within 36 months of closing. For example, say that the new loan has total costs/fees of $2,000, but the new loan lowers the borrower’s monthly payments by $100. In this situation, the borrower would recoup all costs/fees in 20 months ($2,000 in costs/fees / $100 in monthly savings) – less than the required 36-month period.

Requirements for Type 1 non-VA to VA Refinance

• At least one of the above net tangible benefits to the borrower

Type 2 Cash-out Refinance

A type 2 refinance represents the traditional cash-out refinance, with the borrower pocketing the difference between the new and old loans as cash. More precisely, a type 2 cash-out refinance occurs when the loan amount of the new loan is greater than 100 percent of the payoff amount of the loan being refinanced.

Requirements for Type 2 VA to VA Refinance

• Seasoning certification
• At least one of the above net tangible benefits to the borrower

Requirements for Type 2 non-VA to VA Refinance

• At least one of the above net tangible benefits to the borrower

Applying for a VA Cash-out Refinance Loan

To apply for either type 1 or type 2 cash-out refinances, borrowers should take the following steps.

Step 1: Confirm Eligibility

Veterans and current service members must demonstrate cash-out refinance eligibility via a Certificate of Eligibility, or COE. This document serves as proof to lenders that you actually qualify for a VA loan. If you haven’t already done so, you can apply for your COE directly on eBenefits.

Step 2: Find a Lender

Armed with your COE, you next need to find a VA-approved lender. Once again, the VA does not actually provide loans. Instead, you’ll borrow from a bank, mortgage company, or credit union when you complete your VA cash-out refinance.

As with any large purchase, you shouldn’t jump at the first offer. Make sure to research a few different lenders to determine which terms make the most sense for your situation.

Step 3: Provide Required Info to Your Lender

Similar to the original mortgage, you’ll need to provide your lender financial documentation during the VA cash-out refinance process. In addition to your COE, lenders generally require the following documents:

• Paystubs from the most recent 30-day period
• The previous two years’ W-2s
• Federal income tax returns for the past two years
• Any other documentation of income or debt affecting the loan application

While the lender reviews this documentation during the underwriting – or approval – process, they’ll also order a home appraisal. A VA-approved appraiser will determine how much your home is worth, which in turn will confirm how much you can borrow with your VA cash-out refinance.

Step 4: Close on the New Loan

The last step to the VA cash-out refinance is actually closing on the loan. This entails answering all final questions your lender has about your financial situation, paying the closing costs, and signing the final loan documents with a settlement agent or attorney. It can take up to several days for the paperwork to be filed, but after the closing, your cash-out refinance proceeds will be distributed – either as a hard-copy check or, more likely, a wire directly to your bank account.

Of note, most veterans need to pay a VA funding fee as part of their cash-out refinance. For first-use loans, this fee is typically 2.15% of the loan amount. For subsequent loans, it’s 3.3%. However, certain service-disabled veterans and surviving spouses do not need to pay this fee. If you believe you fall into one of these categories, you can confirm directly with the VA.

Final Thoughts

Cash-out refinances provide borrowers a great option to change loan terms and convert their home’s equity into cash. But, before applying for a VA one, borrowers should understand the unique requirements to the type 1 and type 2 cash-out refinances. Depending on whether you want to pull cash out or simply refinance into new a new rate and term, you’ll need to meet specific criteria. Additionally, refinancing from a VA loan will have different requirements than refinancing from a non-VA loan.

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Maurice “Chipp” Naylon spent nine years as an infantry officer in the Marine Corps. He is currently a licensed CPA specializing in real estate development and accounting.

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