Ask Liz Weston

Dear Liz: My son recently learned that he likely will lose his job April 1. He is a fireman and there is a chance the layoff might be temporary, depending on city budget negotiations.

If he loses his job he will not have the income to keep his house, where he is upside-down. He owes $300,000 and the house is valued at $190,000.

He just paid the February payment and is now unsure what to do next. He doesn’t want to lose his house but he is currently living paycheck to paycheck and certainly can’t afford the payments without a job.

Should he stop making payments and let it go into foreclosure, which will ruin his good credit rating that he has worked so hard to maintain? Will the bank work with him to modify his mortgage before he loses his job? Could I buy the home in a short sale to keep the home in the family?

Answer: To answer your last question first, probably not. To get a short sale approved, lenders typically want an “arm’s length” transaction to avoid the possibility of fraud.

Your son should talk to a housing counselor approved by the U.S. Department of Housing and Urban Development. He can find referrals at www.hud.gov. The counselor can review his situation, discuss his options and help him navigate the loan modification process, if that’s the route he chooses.

If his unemployment is indeed temporary, he may only need mortgage forbearance (a temporary suspension of payments) or a short-term modification to keep his home. Either could negatively affect his credit, but the consequences would be less severe than the damage done by foreclosure.

Even a single skipped payment can knock 100 points off his credit scores, so he should avoid missing payments until he’s decided on a course of action.

Dear Liz: I lost my job 18 months ago. I am 61 and have back pain that keeps me from standing more than 15 minutes or sitting more than two hours before I have to lie down, which limits my job prospects. I arranged a short sale of my home a year ago to avoid a foreclosure, and recently received a 1099-C form from the lender for $99,000 of forgiven debt. Please warn others about this!

Answer: Don’t panic just yet.

Normally when a lender cancels or forgives debt, you have to include the forgiven amount in your income for tax purposes, which can result in a whopping tax bill.

But the federal Mortgage Forgiveness Debt Relief Act of 2007 provides an exception for homeowners who lose a home to foreclosure, sell it for less than they owe in a short sale or have their debt reduced through a mortgage modification.

You still have to report the forgiven debt on IRS Form 982, but it’s typically not included in your income for federal tax purposes if:

• The home was your primary residence (second homes, vacation property and rentals don’t qualify).
• The forgiven debt was $2 million or less ($1 million for a married person filing separately).
• The debt was forgiven in calendar years 2007 through 2012.

For more information, visit the IRS’ website at http://tinyurl.com/5pe43f. Details can also be found in IRS Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments.

You’ll have to do a little research to see what you might owe under your state’s income tax laws, which could differ. California, for example, hasn’t updated its law to conform with the federal law for mortgage forgiveness occurring on or after Jan. 1, 2009, although there are several bills pending in the Legislature to do so.

If you’re in California, you might want to bookmark this Franchise Tax Board page at http://tinyurl.com /yhx89zw and check back before filing your taxes April 15 to see if you get any relief.

Dear Liz: My son lives in an area where the real estate market took a major hit. His first and second mortgages total $320,000. The value of his home is now $180,000 to $200,000. He has a good job but is having trouble making ends meet. He can’t refinance, although if he could this would save him hundreds of dollars.

He is 34 and has talked about just walking away. His credit score is around 800, and he pays all his bills.

If he walks away, how long would it take him to reestablish his credit to buy another home? He has talked to his bank, but for the bank to help, he would have to have lost his job. Please provide advice on what he needs to do. He is getting frustrated living check to check.

Answer: This seems to be Concerned Parent Day.

Your son should first check with a housing counselor approved by the U.S. Department of Housing and Urban Development to make sure he understands all his options. He can find one at www.hud.gov.

A foreclosure or short sale (selling the home for less than what he owes, with the bank’s permission) would trash his credit scores, but with otherwise responsible credit behavior, he could begin rebuilding his credit to near-prime levels within a few years.

He could get another mortgage from a conventional lender two years after a short sale and five years after a foreclosure. He could get a mortgage from the Federal Housing Administration two years after a foreclosure.

Once he understands his options, he’ll still have to make a decision about whether he’s comfortable walking away from this debt. Many people believe they have a moral obligation to pay a mortgage if they possibly can.

Dear Liz: My wife and I plan to buy a condo next year, so we want to keep our credit scores as high as possible. One of her credit cards, an airline mileage card, has doubled its annual fee and she’d like to close the account but we’re worried about the damage to her credit scores. She has excellent credit but not a terribly long credit history.

Can she switch cards while maintaining a continuous credit history with this provider? Or would this switch require her to cancel the existing account and start a new line of credit with this provider?

Answer: Most people with good credit worry too much about the effect of closing a single account. You’re probably right to worry, though, because her credit history is short and you’ll be in the market for a mortgage soon.

She should call her issuer and ask if her history with this card could be transferred to the new account. If not, it might be worth hanging on to the card until you’ve gotten the mortgage you want.

Dear Liz: I have high credit scores, no debt, a large retirement fund including a generous pension and a home I own free and clear. I plan to retire in four years and am thinking of moving to be near family.

Should I buy my retirement home now while real estate values and interest rates are low? I could make a 20% down payment and rent it out until I can move in. I should be able to sell my current house and pay off the loan when I retire.

Or should I just be patient and buy a place after I retire? If I wait, I could pay cash for the next house, but property values may rise, and I suspect they’ll rise faster in my future town than in my current one.

Answer: Getting a loan to buy a rental property is difficult these days. Although your high credit scores and solid finances will help, you may have to come up with a down payment larger than 20%, and your interest rate almost certainly will be higher than if you planned to live in the home right away.

Then there are all the issues associated with being a long-distance landlord. You would need to screen tenants, respond quickly to repair requests and keep a substantial reserve fund to pay the mortgage when the property is vacant. A property management company could help, but such outfits typically take 10% or more of any rent payments.

Also consider that your plans could change. Although being close to family is important, you may decide you don’t want to give up ties to your current home or its environment.

If you haven’t spent a substantial amount of time in the area where you plan to move, consider taking a long vacation there when the weather is at its worst so you have a good idea of what life there might be like.

That’s not to say your plan can’t work, but you need to do some research, carefully go over the numbers and think about whether you’re up to this task.

Dear Liz: I’m a Realtor with a client who has a 719 credit score. If we could get that score one point higher, he could save $5,000 on his home loan. His score was 45 points higher four months ago, and the only change was that one lender pulled his credit a month ago. Can we dispute the huge drop given that nothing else happened? What else can he try?

Answer: It’s extremely unlikely that one inquiry dropped his score by 45 points. Chances are something else changed on his credit reports. Check the balances and credit limits his credit card issuers are reporting. Any narrowing of the gap between the two (such as higher balances or lower limits) could have contributed to the sudden drop.

You can’t really dispute a credit score drop, but if incorrect information is being reported by his lenders, you can dispute that.

In any case, he should be able to boost his score by getting those balances down, preferably below 10% of his credit limits. Even if he pays his balances in full every month, he needs to be concerned about his credit utilization, since the balances reported to the credit bureaus are typically the balances on his last statements.

Dear Liz: We refinanced our house in January for a 30-year fixed rate of 4.625%. We are paying about $513 a month extra toward the principal, which will allow us to pay off our mortgage in 16 years.

We have 20-year term life insurance policies to cover the mortgage in case the worst happens to either of us. Both my husband and I contribute to our 403(b) retirement accounts at work.

However, we don’t have any emergency cash fund in our banks. We figured we can always borrow from our 403(b) accounts. We both have good credit scores (above 750). We have no debt besides our mortgage.

Any financial advisors out there would tell us to invest that $513 a month into mutual funds or stock because of all the good reasons that I’m sure you know better than us.

However, this is how my calculation works: We’d be saving about $100,000 interest if we pay the mortgage loan off in 16 years. On top of that, we won’t have to make any payment for the remaining 14 years, which would be almost $200,000. The total saving is about $300,000.

Is there any mutual fund out there that can yield that much money if we decided to invest in it? Is it a good idea to do what we are doing right now based on our financial situation?

Answer: Actually, $513 a month invested in a mutual fund would result in about $765,000 after 30 years, assuming an average annual return of 8% (which is the minimum investors have received in every 30-year investing period since 1928, according to Ibbotson Associates).

Even if you look just at the 16-year repayment period, investing the money would recoup about twice what you expect to save in interest.

Now, you could probably build a substantial nest egg if, as soon as you paid off the mortgage in Year 16, you started investing your mortgage payment plus the extra $513. But you’d never make up the ground lost by not investing the monthly $513 from the start.

Also, you need to consider more than potential investment returns when deciding to prepay a mortgage. You have to look at your entire financial picture and make sure all your bases are covered before you pay off a low-rate, potentially tax-deductible debt.

Your lack of an emergency fund is worrisome. Yes, you can tap your retirement funds, but those loans could become taxable, permanent withdrawals if you lose your jobs and can’t pay the money back.

It’s far better to have cash in the bank to cover the unexpected expenses and financial setbacks that life can present.

You should have, at a minimum, an emergency fund equal to three months’ worth of basic expenses before you consider prepaying your mortgage. A fund equal to six months’ worth of expenses is even better.

Since you’re a homeowner, you also should set aside a separate, sizable amount to cover major home repairs — $2,000 at least, although $5,000 is better.

Dear Liz: When does it make sense to refinance a home? I have a 30-year, fixed-rate jumbo loan. The loan is just over 2 years old with a rate of 6.5%. Should I refinance to 5.75% with zero points? I make extra payments every month with the intention of paying the loan off in 15 years, but I don’t want to be locked into a 15-year rate in case I have some difficult times.

Answer: There are no hard-and-fast rules about when to refinance. When refinancing costs were higher, you typically needed a 2-point drop in rates for a new loan to make sense, but that’s no longer true.

Generally, though, you should avoid refinancing if the new loan wouldn’t recoup its costs within two years. Although the loan you’re considering doesn’t charge “points” — a percentage of the loan paid to lower the interest rate — you’ll still be charged other fees. If the lower payments would offset those fees within 24 months, and you plan to stay in the house at least that long, you might consider replacing the loan.

Another factor to consider is how much longer you’ll remain in debt with a new loan and how close you are to retirement. Ideally, you’ll want to be mortgage-free by the time you quit work.

When you’re just a few years into your loan, as you are, this is less an issue than if you’ve paid down your mortgage for five or more years. In the latter case, you should either consider opting for a shorter loan — 15 or 20 years, say — or make extra payments on a 30-year loan if you otherwise wouldn’t pay off the mortgage by the time you’re ready to retire.

Dear Liz: We’re refinancing our mortgage and home equity loan and will be paying about $200 less per month. Would we be better off applying this extra money toward the mortgage so we can pay it off in less than 15 years? Or would it be better to put it into savings or invest it?

Answer: Most people have better things to do with their money than pay off a low-rate, tax-deductible debt such as a mortgage — especially if you’re already on the road to paying it off in 15 years.

You should first make sure you’re on track with your retirement plan. If you’re not already getting the full company match from your 401(k) or 403(b), that extra $200 could win you an instant 25% to 100% return, depending on the generosity of the company match.

Even if your plan doesn’t have a match, you could get a tax deduction on your retirement contributions that you won’t get paying down the principal on your mortgage. Plus, your money is likely to earn greater returns over time than what you’d net by paying off your loan early.

If you’re maxed out on saving in your workplace plan, consider contributing to a Roth IRA. If you’re on track for retirement, paying off other debt and bolstering your emergency fund would be the next smart moves. Once that’s done, review your insurance coverage to make sure you’re adequately protected on the life, disability and long-term-care fronts.

Only after you’ve got all your financial bases covered should you consider accelerating your mortgage payments.Don

Dear Liz: Are banks still lowering the amount of available credit? I’m concerned because we were hoping to use our home equity line of credit to pay for our children’s college educations, if need be.

Our current balance is less than 5% of the total available limit, but my credit reports show our credit line lender recently reviewed our credit history. I am concerned that our bank will lower our available credit as my son is about to start college. Are my concerns valid?

Answer: Perhaps. Lenders have been reducing home equity lines of credit as home values drop. If your mortgage balance and your line of credit total more than 60% of the current value of your home, you may be at risk of having your limit reduced right when you planned to use it.

If that’s the case and your son is heading off to school in the next year, it might be prudent to withdraw the money now and keep it in a savings account.

If college won’t start for several years, though, you might want to explore other options, since it’s generally not a good idea to borrow money so far in advance of when you’ll need it.

Fortunately, you have plenty of options when it comes to paying for college. Just make sure you fill out a Free Application for Federal Student Aid. Even if you don’t qualify for need-based aid, filling out the FAFSA will allow you to apply for federal student loans. Your son can get Stafford loans at a 6.8% fixed rate and you could get PLUS loans with a fixed rate ranging from 7.9% to 8.5%. Although the amount of student loans your son can get is generally limited to $31,000 for an undergraduate degree, PLUS loans allow you to borrow whatever you need to cover any costs not paid for by the student’s financial aid package.