In an interesting article in today’s Business section of the Washington Post, financial reporter Dina Elboghdady explains that the FHA will no longer back refinancing that allows the borrower to bring “cash out” of the transaction.

The “cash out” is a way for many folks to get that little bit of extra cash out of their house for things like their childrens’ college education, home improvement and, yes, big flat-screen TVs and nice vacations. The problem seems to be that many people are not even getting past their first payment before going into default on these types of refinances. In fact, recent analysis shows that many people who have sought loan modifications to make their monthly payments more affordable either through a reduced interest rate or reduced principal of their mortgage balance go into default anyway.  This really means that many, many people bought homes they could not afford and regardless of the help that is offered to them, they just can’t keep up with the mortgage payments.

Refinanced loans now make up two-fifths of all the agency’s instant defaults, according to the Post analysis, and some lenders have singled out cash-out refinances as especially risky. With conventional loans, many lenders now offer cash-out deals only to people with top-notch credit and significant equity in their homes. The fear is that borrowers might otherwise take the cash and walk away from the loan.

—from FHA to Tighten Standards for Cash-Out Refinancing

As a result, FHA is cracking down and tightening up it’s credit standards to prohibit people from digging themselves too deep into the hole.  There is a way to get some cash out.  You must have at least 15% equity in your home. Of course, this is hard to do for folks who purchased their home in the last 10 years.  A lot of people took out 100% financing or “interest only” financing and they have not reduced their mortgage principal enough.  Even people who took out conventional mortgages with 10% or more of a down payment have seen their home values erode.  Thus, even responsible home owners may not have the equity in their homes that FHA requires for cash out refinancing.

In many ways, this is all too the good.  Since many people are continuing to default on their mortgages even after they’ve been modified or they’ve gone into default within a payment or two of a refinance of their home it makes sense to put the brakes on.  It is time, in my view, to end the free flow of money and credit to people who, flat out, cannot afford a mortgage.  That is why the rental market exists.

There are two ways for us to get out of this crazy housing slump:

1. Banks must sell (in the case of bank-owned properties) or approve for sale (in the case of “short sales”) the houses that are causing this huge inventory of unsold homes and,
2. Responsible lending practices must prevail.

There are plenty of home buyers in the world with decent credit, low debt-to-income ratios and family income levels that support owning a home.  Many of these home buyers would buy homes at current price levels and in their current dilapidated condition…if banks would only approve their sale!