Short sale cash-out won’t work

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Dear Dr. Don,
We are a growing family and have come to the conclusion that we need a bigger home. We both have good credit scores, but we do carry credit card balances and have a loan payment on our truck. We want to use mortgage debt to pay off these loans.

Is it possible to find a short-sale or foreclosed home with enough equity built in to cover our debt and just make one loan equal to the taxable value of the house? We would be OK with breaking this into a second mortgage or an equity loan as well.

For example, let’s say that a home’s taxable value is $250,000. The home is in foreclosure and is selling for $175,000, so it has “built-in equity” of $75,000.

Could we take out a loan(s) for the whole $250,000 and use the extra $75,000 to pay off other debts, making it more economically viable for everyone involved by having us close to debt-free (apart from the secured loan on the house)?
— JR Restructure

Dear JR,
If you think you can trade up to a home that better meets the needs of your family, it’s an opportune time to find a home at a low price with reasonable financing. It may even be a short sale. But it’s the wrong time to try to work the appraisal process to take $75,000 in cash out at closing when that would result in a loan that’s 142 percent of the purchase price of the home.

I don’t think your idea is workable. Home loans are based on either the home’s appraised value or its market value, not its taxable value. The taxable value (or, in some cases, assessed value) is used to determine the property taxes, not the loan size. It’s the appraised value or market value, along with your income and credit history, that determines how much the lender is willing to lend on the home.

With a short sale, the original owner works with his or her lender to sell the property at a price the lender will accept as satisfaction of the owner’s outstanding loan balance. If there’s a second mortgage, the second mortgage lender has to sign off, too. Read the Bankrate feature, “10 steps to ‘short-sale’ buying,” for more on buying a home in a short sale.

The accepted offer determines the market value of the house. The house may appraise for a value higher than the accepted offer, but a lender will use the lower of either the appraised value or the market value in determining how much it is willing to lend. In your example, if the appraised value was $75,000 over the price of the $150,000 short sale, it’s unlikely that the bank would have agreed to the short sale in the first place.

On the budget side, when you restructure your credit card debt into mortgage debt, it should reduce the interest rate, and you’ll gain a potential tax deduction for the interest expense. But you’ve just bet the house on being able to keep your spending under control. The truck loan was already a secured loan, but rolling it into the mortgage raises the ante on keeping your spending under control.

From a budgetary perspective, consolidating credit card and truck loans into the mortgage just restructures the debt — it doesn’t erase the debt. Taking 30 years to pay off the truck and your credit card bills doesn’t save you money in the long run, although you may get a tax deduction for the mortgage interest expense.

To ask a question of Dr. Don, go to the “Ask the Experts” page, and select one of these topics: “Financing a home,” “Saving & investing” or “Money.” Read more Dr. Don columns for additional personal finance advice.