Real estate matters: Mortgage Q&A

A foreclosured home for sale in Spring, Texas. A foreclosured home for sale in Spring, Texas. (Aug. 22, 2006) Photo Credit: AP

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Q. Does the former owner of a foreclosed home have to pay earned-income tax on the difference between what was owed to the lender and what the lender receives?

A. When a home goes into foreclosure or is sold in a short sale, there is usually a significant difference between the amount owed and the amount the lender ultimately collects.

If a lender decides to write off the amount owed but not collected from a borrower, the borrower receives a benefit as a result of not having to repay that amount. However, if the borrower agrees to repay the amount unpaid after the foreclosure, then the borrower can and will continue to make payments to the lender until the loan is paid off.

The difference between what is owed and collected from a short sale or foreclosure by the lender is known as the deficiency. Once the lender writes it off, the homeowner is obligated to report the deficiency to the IRS. There is a temporary and conditional exception: Through the end of 2012, the IRS will not treat the deficiency on the sale of a principal residence as phantom income that must be taxed.

Q.

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My husband and I have two houses. We live in one of them. We turned the other into a rental property. We are not underwater in either home. We both have stable income and great credit scores (around 790). We'd like to refinance our loans to get a lower interest rate and take cash out of the rental property. But the mortgage company came up with the condition that we have to close three of our credit cards before it will approve the loan. Why are they demanding these unreasonable conditions?

A. You are a great example of why lenders aren't always making smart decisions when it comes to lending money to borrowers. On paper, you look like a sure bet. The problem is that you want to do a cash-out refinance, which makes lenders very nervous these days. They don't understand why you want to do a cash-out refinance, and assume it is because you are in financial trouble.

Still, it's a rental property, and there are limitations on what lenders are able to do when it comes to refinancing investment properties these days. Having you close credit card accounts might make the lender feel better about what you could borrow after closing. A better idea is to shop around among different lenders. Find a company that wants to work with you. Try a credit union, local or regional banks, or even an online lender. A local mortgage broker might know of other lenders that would be interested in refinancing your loans.

Q. The value of my home has decreased by close to $500,000, and I am on an interest-only loan for five more years. I would like to stay in the house, but I am not sure my bank will agree to a loan modification. I can pay my monthly mortgage, but I have no savings except for money in my 401(k). I would like to have a fixed interest rate with a lower monthly payment. Can you offer any advice?

A. You're in a very tough situation. First, your loan amount is so high it can't be guaranteed by any federal agency. And you don't qualify for the Making Home Affordable loan modifications or the federal HARP program, which is for people who are underwater and want to refinance.

The biggest problem you have, however, is that your loan is only going to last for five more years (unless it converts to a one-year adjustable at the end of that time and starts the amortization process). At that time, you will need to be in a position where you can qualify for a refinance. It seems you would not qualify now, with the strict financing requirements.

If home values don't rebound in five years, you would have to come up with hundreds of thousands of dollars in cash so the loan-to-value ratios work. You might want to reconsider selling or renting your property.

Q. Will putting more money down affect the interest rate on a loan?

A. The more you borrow, the more you have to pay in monthly interest payments to your lender. Some people want to borrow as much as possible today, given the low interest rates available. If you use your only savings to put down on the loan, you might want to think about where you'd invest the cash if it wasn't put toward the home. You also should consider whether you will need that money for a rainy-day fund in the future.

If you have other rainy day cash available, and you are just wondering when is the optimal time to prepay your mortgage, then the question you have to answer is, what is that cash doing now? If it is in a savings account earning nothing, and you can prepay your loan that is costing you 4 percent (let's say), then you've effectively earned 4 percent on that money. It's good money sense.

You should talk to a good mortgage lender or mortgage broker to walk through your options. Ask him or her to tell you what your rate and costs would be on your new loan if you put down $30,000 or $60,000.

Ilyce R. Glink's latest book is "Buy, Close, Move In!" Samuel J. Tamkin is a Chicago-based real estate attorney.

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