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I just need enough equity to refinance out of the Pay Option I suppose.

Unfortunately, by turning the home into a rental property, you have raised the amount of equity you will need to be able to refinance. In the current credit environment, investor properties generally require at least 10% equity to refinance, while owner-occupied properties may require as little as 3% - 5%. And by making minimum payments on the Pay Option ARM, you are limiting your equity growth rather severely.

Is there any way you could afford to move back into the home?

If you cannot afford to move back into the home, you are unlikely to get much help from the lender. Lenders are all focused on helping homeowners stay in their homes. Investors are pretty far down on their list, as the publicity from investors losing their assets is not nearly as bad as the publicity from tossing families out of their principal residences.

Also, from a tax standpoint, while homeowners who have mortgage debt forgiven because of a short sale or foreclosure this year and next will have no taxes due on the 'income' that they derived, investors will have taxes due. So it is really in your best interest to make the home back into your principal residence if you can possibly afford to.

I really want to avoid a short sale - isn't it my ethical duty to do so as well? I suppose the lender will see no delinquencies as of yet, so probably wouldn't even do the short sale...

If you haven't had any late payments on the mortgage, and if you have other assets, the lender is unlikely to work with you, especially since the home is no longer your primary residence. Especially if there is some equity in the home, which you seem to indicate there is, the lender would rather have you pay off the mortgage with whatever assets you have, rather than do a short sale. If you are upside down in the home, it will again depend on what your other assets are, and if your state allows deficiency judgements. Apparently New Jersey does allow them:

If you have other assets, you may be forced to liquidate them in order to satisfy either the deficiency caused by a sale for less than is owed on the mortgage, or the deficiency caused by a foreclosure.

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