In the wake of the housing bust, lenders are sharpening their focus on borrowers’ credit scores. Putting aside how ironic this is – given that the credit score has proven to be a less-than-perfect indicator of creditworthiness – it’s vital that (potential) borrowers understand how the credit score will be used by lenders, and how the score can be maintained at an attractive level.

Before you even begin shopping for a mortgage, you should first make sure that your credit score is as high as possible. Ideally, this should be done a few months in advance, so that any changes are reflected in the credit score by the time it is pulled by the lender. Namely, you should double check your credit report for errors and pay off all of your consumer debt. If possible, you can try to borrow money from friends, so that your financial position appears to be as strong as possible.

Consider also that your lender will require additional financial information to supplement your credit score. You will be asked to furnish proof of your income and assets. If you are self-employed and/or unable to do so, you may be able to obtain a so-called Stated Income/Stated Assets Loan or No Documentation Loan. In light of the credit crisis, however, these loans are difficult to obtain. Even if your credit score is quite high, you should expect to pay a premium on your mortgage rate and make a larger down-payment.

Your credit score and financial attributes will be verified again upon closing. This is a new requirement, mandated by Fannie Mae on June 1: “If a broker or lender finds significant changes, the loan could be delayed, or in some cases, denied.” Accordingly, you should make sure that you continue to exercise the same prudence until the loan is officially closed. According to one analyst, “ ‘Just one point in a credit score can change things tremendously. And potentially, they may not qualify for the loan.’ ” At the very least, you might incur additional fees.

Finally, your credit score will continue to be affected depending on how diligent you are in repaying your mortgage. If you promptly make payments every month, your credit score will gradually improve.This will simplify the process of refinancing your mortgage or obtaining a new loan in the future. If you make even one late payment, however, your credit score will be materially impacted. If you default on your mortgage, your credit score will be devastated, and it goes without saying that you will have difficulty obtaining financing for anything for at least a few years.

In short, while the credit score is both annoying and even somewhat pointless, remember that lenders take it very seriously. Unfortunately, that means that you should do the same.

While accurate statistics have been difficult to obtain, anecdotal evidence suggests that so-called Lease-to-Own Options are increasing in popularity. Under such arrangements, the homebuyer will pay rent to the seller for a fixed amount of time, after which he has the option to purchase the home outright. In this way, “Homebuyers save toward the purchase — often, a portion of the rent is designated for the down payment — while giving the seller some rental income in the meantime.”

The precise mechanics vary according to each situation, but “Most lease-option deals involve a two-year lease that can be extended to three or four years if a buyer’s credit isn’t expected to be good enough to obtain a mortgage after only two years.” In some situations, the lease can be as long as ten years. After its expiration, the buyer has the option to buy the home for a price that is agreed-upon in advance. Because of the uncertainty surrounding the current housing market, however, many lease option contracts are currently being written without negotiating a sales price.

These arrangements offer two main benefits to the homebuyer. First of all, it affords one the opportunity to “try out” a house before committing to buy it. Secondly, it can ease the financial burden of home ownership: “Local experts say rent-to-own agreements, also called lease options, are a way for prospective buyers with cash shortages or credit problems to build up a down payment while repairing their credit.” This financing approach is especially useful for luxury homes, which has been plagued by “the worst environment for jumbo lending in the last 20 years.”

There is no necessary financial benefit to the seller, other than it could allow him to attract a buyer that otherwise wouldn’t be able to afford the property. Some experts warn, however, that “Lease-option agreements rarely result in sales because buyers back out or fail to qualify when the lease expires.” Unfortunately, real estate agents may be especially guilty in highlighting this negative, since their fee structures are slanted towards outright sales, rather than lease options.

Ultimately, if this type of financing is intriguing to you, there’s no reason not to ask the buyer to consider it, if it can help to close the deal. Here are some issues to consider: “How much of the rental payment will go toward the down payment? Will the renter pay above-market rent to compensate for the down payment fund? Who will handle maintenance and repairs?” Another expert recommends that you, “Don’t agree to an ‘option fee,’ or non-refundable deposit, larger than what you can afford to lose if you decide not to buy.” Of course, you should also remember to speak to a financial counselor to make sure that it’s appropriate for you.

In yesterday’s post, I expounded upon a new trend in the foreclosure crisis – the “strategic default” – whereby underwater borrowers deliberately make a calculated decision to stop making payments on their mortgage. “Current lending practices have created an environment where a measure as extreme as abandoning a home actually makes sense to some people. Many buyers put little or no money down, so they don’t have much invested in them. That leaves them with little incentive to keep making payments when a home’s market value dips below the balance of the mortgage.” With today’s post, I intend to develop this thread further to explain how default (strategic or otherwise) affects one’s credit score.

It turns out that this impact is relatively modest, especially when you compare it to continuing to make payments on a mortgage that well exceeds the value of one’s home. Obviously, borrowers can expect to see their credit rating deteriorate overnight, by a significant margin – as much as 200 points. In addition, it will be nearly impossible for one to take out a new mortgage (or any other significant loans, for that matter) for at least a couple years. The exact duration depends on many factors, namely the borrower’s credit score at the time of default. Ironically, “The higher the score, the greater the damage.”

However, the credit scoring system is such that continuing to make mortgage payments in lieu of payments on other debt instruments (such as credit cards and auto loans) might actually be more detrimental in the long run. ” ‘While a mortgage default can savage a person’s credit record, trying to pay off a loan they can’t afford could be worse for borrowers if it leads to bankruptcy,’ ” said one source. “Credit scores are hurt much more by missing multiple payments – on credit cards, cars and so on – than by a single foreclosure.” In other words, it would take longer for your credit to heal (i.e. a longer wait before you could take out a new mortgage) if you declared bankruptcy, than if you defaulted on your mortgage, even though the Dollar amount of the latter is in most cases much larger than the former.

What about the alternatives? A short sale is now an increasingly attractive option for many borrowers, “thanks to the Mortgage Debt Relief Act of 2007. Previously, if a bank sold a foreclosed home for less than the mortgage balance and it forgave the difference, the borrower had to pay tax on that difference as if it were income. Now the IRS will ignore it.” Even though short sales don’t show up directly on one’s credit report, they are still incorporated into the credit score as a negative event.

The same goes goes for a deed in lieu of foreclosure, in which “the borrower turns over the deed to the property to avoid foreclosure and settle the debt.” While such can help one avoid the delinquent payments normally associated with foreclosure, the deed itself will still show up on the report. According to one source, the logic that one of these choices is better than the other is just plain wrong: ” ‘Someone out there is passing along a rumor that a short sale is better for your credit than a foreclosure or even a deed in lieu of foreclosure,’ he said. ‘All are equal in the eyes of FICO.’ ”

Even loan modification can negatively impact one’s credit. One would think that by preemptively contacting one’s lender (especially before the mortgage becomes delinquent) would receive favorable treatment in the eyes of credit scoring agencies. Unfortunately, their rubrics assume that modified loans are more likely to result in default: “We view an account that has been settled or renegotiated for less than the full amount as a negative because historically consumers on reduced payment plans represent a greater risk,” explained one expert. While loan modifications are generally less punitive than foreclosures, the credit hit can still be significant. It’s no wonder some borrowers are electing to simply walk away.

Too many people borrowers make the mistake of shopping solely on the basis of interest rate, and don’t pay enough attention to the closing costs. On the surface, this approach makes the most sense since interest costs dwarf closing costs. However, while many lenders might offer similar interest rates (because such rates come from the markets, and are hence relatively uniform), they might differ dramatically on closing costs.

Closing costs can be categorized in accordance with a variety of parameters. Some experts like to divide costs into fees paid directly to the lender, fees ordered by lenders but paid to third parties, fees paid directly to third parties, and miscellaneous settlement costs. I’ve also seen fees broken out into additional categories, such as pre-paid insurance/taxes and title/attorney fees. While it’s justifiable to segment fees into as many categories as you feel comfortable dealing with, personally I think it’s reasonable to distinguish only between lender fees and non-lender fees, especially when initially shopping for a lender.

It can be tempting to make a blanket comparison between multiple lenders using the total settlement costs listed on the good faith estimate. However, more than half of these costs are probably estimated non-lender costs, and the lender could deliberately underestimate these costs to increase his appeal. Thus, it makes sense to really scrutinize lender costs, rather than third-party costs, when selecting a lender.

Which costs fall into the category of lender costs? The biggest fees are the origination fee and discount points, which are paid up-front for a lower interest rate. While discount points correspond to the interest rate and may be difficult to negotiate, the origination fee is based on the discretion of the lender/loan officer and can hence be negotiated. The same can be said for processing, underwriting, and application fees. All of these fees should be guaranteed by the lender upfront, in absolute Dollar terms if possible. Don’t worry about comparing individual line items between lenders, since these are often meaningless; you should focus instead on total lender fees.

Non-lender fees include appraisal, credit report, pre-paid insurance/taxes, pre-paid interest, legal fees, title fees, recording fees, inspection fees, etc. Some of these fees are ordered by the lender, and thus, should be guaranteed in writing. Fees that are paid directly to third parties can naturally be negotiated directly with the third party. Government fees are usually fixed, and hence not worth fretting over.

Negotiating closing costs have always been a frustrating part of the mortgage experience because it’s difficult to know what to pay. While interest rate information is published, closing costs are not. There are a handful of lenders that guarantee their dollar fees, but most are internet-based, which can add another factor into the selection process. Perhaps more useful are informative – rather than commercial – websites: “Closing.com, a site that can create instant closing-cost estimates as would-be borrowers search for the best or least expensive real estate service providers, has a vendor database of nearly 150,000 firms in 14 categories. And fairmortgage.org has dozens of lending organizations that promise to offer safe mortgages at fair prices.” Both sites offer confirmed prices for local lenders, customized for the type of home you are buying. Looks like negotiating closing costs just got a whole lot easier.

In the mortgage game, many potential borrowers simply shop around for the best deal, and simply compare the rate quotes that lenders offer them. This approach, however, is somewhat passive, as it ignores one very important step: researching and improving your credit score. In light of the housing and credit crises, banks are relying increasingly on the credit score as a risk metric, so it’s crucial that you understand how the process works.

While every lender utilizes credit scores slightly differently, there is still a consistent relationship between the strength of the score and the “competitiveness” of the mortgage. In other words, one lenders might have 5 interest rate tiers which correspond to five credit score levels. Other lenders might have 3 tiers, or 10 tiers. Still other lenders might have minimum credit score requirements for certain types of mortgage. But the fact remains, the higher one’s credit score, the better/cheaper the mortgage is.

The credit score formula evaluates payment and credit history, utilization, new loans, types of credit in use, and the age of accounts. Generally speaking, your credit score will be highest if you pay your bills in time, have a small amount of debt (but not zero debt) relative to your credit limits, and have older and fewer sources of credit.” While dozens of different credit scoring formulas have been developed, the Fair Isaac Corporation’s FICO score has long been the industry standard. The exact formula is a closely guarded secret.

As part of the Fair Credit Reporting Act, you are entitled to view your credit score free once a year. Unfortunately, this rule might be doing more harm than good, since the free score that you can expect to receive probably isn’t your FICO score, but a score calculated using the specific reporting agency’s proprietary formula. Sometimes, there are wide disparities between different companies’ scores, such that the number you receive may not be entirely useful. Still, it’s important to review your credit report itself for errors, and to file a complaint if you discover any.

If your credit score is lower than you want/need, there are a couple steps you can take to improve it, most of which are self-evident. Namely, pay off any outstanding balances and cancel any credit cards that you aren’t currently using. In addition, have yourself removed as an authorized user on any cards that you don’t use since delinquent payments on such cards (by other authorized users) could negatively affect your credit. At the same time, don’t worry about consolidating debts under fewer cards, since this won’t meaningfully affect your credit score. Also, be advised that (sometimes arbitrary) cuts in credit limits can negatively impact your score because they increase your utilization rate.

While it may take years for such these measures and other responsible borrowing practices to result in an improved score, you could see a slight bump in only a few months. If there’s one particular blip on your credit score, it doesn’t hurt to submit a letter of explanation to the mortgage lender, in which you make it clear that extenuating circumstances (i.e. job loss, illness, personal issues) caused a temporary interruption in an otherwise seamless history of good behavior.

As I started to explain in yesterday’s post, government is keen to help borrowers and homeowners in need. More than $75 Billion has already been allocated towards helping homeowners avoiding foreclosure. An additional $1.5 Trillion has been deployed by the Federal Reserve Bank; as part of its quantitative easing plan, it has purchased mortgage securities in bulk, which has helped to keep mortgage rates relatively low.

Both of these programs have targeted those who already own homes, by allowing them to lower their monthly payments through loan modification and refinancing. What about those who aspire to own homes but don’t currently have a stake in the system? This is where the tax credit comes in; both the Federal government and select state governments are now offering qualifying homebuyers a break on their taxes if they purchase a home before a certain date.

“As of May 29, 2009, the $8,000 federal tax credit can be used as ‘an additional down payment or closing costs’ for buyers who apply for mortgages insured by the Federal Housing Administration before Dec. 1, 2009″ and must have been purchased after January 1, 2008. There are two key stipulations: first, the credit is limited to first-time home buyers, defined as not having owned a residence in the last three years. Second, there are income limitations: “A phase-out of the credit begins when the taxpayer’s modified adjusted gross income exceeds $75,000 or $150,000 if married filing jointly. The credit is eliminated completely when the taxpayer’s income reaches $95,000 or $170,000 if married filing jointly.”

In an effort to maximize the benefit of the tax credit, the government has the designed to program to be extremely flexible. First of all, qualifying homebuyers have the option of claiming the tax credit in either 2008 or 2009. In addition, the tax is not only deductible but actually refundable; in other words, “This means that even if you don’t owe the government money in taxes, you can still take part in this incentive program,” as the government will simply write you a check for the difference. Finally, the tax credit can be applied immediately in conjunction with the purchase of a home; through the use of a bridge loan, homebuyers can use the credit prior to actually filing their taxes. Consult the First-Time Home Buyer Tax Credit website for more information.

While the federal credit is available to anyone who qualifies during the given time period, some state programs are available on a first-come, first-served basis. California, for example, recently set aside $100 million to be meted out in the form of $10,000 credits. In only four months, most of this money has already been distributed; “Some $94.7 million has been claimed via 9,848 applications, according to the most recent data from the state’s Franchise Tax Board.” Better Hurry!

For those of you neither own a home, nor aspire to own one in the short-term, the government is also watching your back. “The Consumer Financial Protection Agency, if approved by Congress, will have broad authority to protect consumers of credit, savings, payment and other consumer financial products and services…It could write rules, reform mortgage laws, examine financial institutions’ practices, enforce compliance through penalties, ban unfair practices and require that companies be “clear and conspicuous” in informing consumers of costs, penalties and risks.” In addition, lenders would be required to offer a “plain vanilla” mortgage (i.e. 30-year fixed rate). Prepayment penalties and yield-spread premiums would be banned, and lenders would “not be able to issue mortgages…that they knew consumers would not be able to pay back.”

I have already blogged about the most important considerations that must be accounted for when deciding whether to refinance a mortgage. With this post, I would like to focus on a few “red flags:” attributes that should cause you to think twice about a re-fi.

The first red-flag is time. From a mortgage duration standpoint, it probably doesn’t make sense to refinance if you are close to (or already passed the halfway point) of your mortgage. For example, if you are 15 years into a 30 year mortgage and refinance into a new 30 year mortgage, you will incur significant additional interest, by effectively lengthening your amortization period by another 15 years. For a modest $200,000 mortgage, this translates into a whopping $60,000 of additional interest payments.

In this case, a better option would be to refinance into a new 15-year mortgage, the net result of which would be no change in the amortization period. If you’re considering such an option, it makes sense to first speak to your lender, who might be willing to modify your interest rate without compelling you to take out a new (i.e. refinanced) mortgage. If a loan modification isn’t an option, the next consideration is how many years you plan to live in your current house. Most experts use two-years as a benchmark; in other words, if you are planning on moving out within the next two years, it will be difficult for you to recoup the closing costs associated with the refinancing.

Red-flag number 3 is your age. If you are nearing retirement age, it probably doesn’t make sense for you to refinance, because then you ensure that you will be making mortgage payments from your savings/pension well into retirement. Who wants to be saddled with such a burden? The only exception is if you have already refinanced in the past and/or have very little equity in your home.

Instead, you might want to consider a reverse mortgage (see yesterday’s post), which allows you to pay off your current mortgage and essentially freeze the equity in your home at a given level (usually no less than 35% of the value of your home) and cash out the difference. As long as you don’t plan to move out/sell your home in the short-term (in which case you “forfeit” some of the proceeds), a reverse mortgage will allow you to remain in your current home indefinitely without having to worry about making mortgage payments (that you would otherwise still be making after refinancing your mortgage).

The final red flag is that you are refinancing for the purpose of debt consolidation/consumption, rather than to save on your monthly payments as a result of a lower interest rate. In recent years, cash-out refinancings have become very common, but I implore you to resist the urge, unless absolutely necessary. It can certainly be tempting to roll all of your credit card debt, auto loans, etc. into your mortgage, which almost certainly has a lower rate. But think of the implications of this: in doing so, you are essentially amortizing the dress you just bought or your car (both of which have limited time use) over 30 years! Besides, if the value of your home goes down, you are now personally on the hook for the difference.

Admittedly, this is probably not a question that many homeowners find themselves asking these days, given the recession that continues to ravage the US. Even regardless of the economy, it’s not an easy question to answer, as I shall explain. The most important consideration is whether you can afford it. That is, if you commit to contributing an extra $50 per month or making one extra payment per year, can you be certain that it won’t negatively impact your financial situation.

As to whether it makes financial sense to repay- this involves a much more complicated calculation. The general idea is that if you can afford to prepay your mortgage, you should make sure that the money you save (by effectively shortening the term of your mortgage) exceeds the return you would have achieved by investing those hypothetical repayments. Thus, you should begin by comparing the rate that you pay on your mortgage to the rate of return that you think that you can reasonably achieve as an investor.

This basic calculation, however, ignores the tax-deductibility of mortgage interest, which must be accounted for in your mortgage rate. In other words, while your mortgage rate is technically 6%, it might fall to 4% on a tax-adjusted basis, after accounting for the 33% you don’t pay, via your marginal tax rate. At the same time, you need to consider that your investment profits will be taxed by the IRS, at a rate that depends on the type of investment. If you put your money in a savings account, it might be taxed as normal income, whereas if you invest in stocks, you will be taxed at the long-term capital gains rate, and will in effect come out ahead in the tax arbitrage game.

Moreover, you should be aware that there is a connection between the risk and return of what you invest in. While a mortgage rate may not fluctuate much over the life of the mortgage (of course it won’t fluctuate at all if it is a fixed-rate), your rate of return might vary from year to year. Interest rate cuts and stock market declines will certainly erode your ability to achieve your projected return.

Ultimately, if you have the cash to spare, it’s probably advisable to repay. Situations where you are reasonably sure that you can achieve a much higher return than your mortgage rate are probably going to be rare. If you were lucky enough to lock in a 6% fixed rate mortgage while your savings account is currently paying interest at 15%, well that’s a different story. While everyone certainly has a different risk-reward matrix, it’s probably still better to build up additional equity in your house rather than gambling in the stock market.

Before prepaying, make sure that there isn’t a prepayment penalty attached to your mortgage. Fortunately, such penalties have become increasingly rare, and if you do have a penalty, chances are it will no longer apply after two or three years. One final piece of advice- make the repayments directly to your lender, rather than through a third-party, which will charge a fee for managing a process that simply doesn’t need to be managed.

According to Mortgage News Daily, in May American Express announced a new credit card which allows home owners to charge their mortgages on their credit card. Enrollment in the program is not cheap, with a one time fee of $395, but if you charged a $2,500 mortgage to your card every month the card would pay for itself in about a year.

Some of the banks who have signed on to the program have already went bankrupt. It is yet to be seen if consumers will benefit from this new credit card, or it is just another way to help them get Maxed Out.

Maxed Out is a great video and book covering the aggressive nature of banks and credit card companies.

It covers everything from

• How credit card companies prey on college students with credit card offers even if they know the students have no way to pay them back
• How some credit card companies hold checks to make payments late and charge late payment fees, overdraft fees, and . You can learn more about Providian Financial online
• How it is far easier for companies to file for bankruptcy than individuals, especially since 2005
• How the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 was written by MBNA – a leading credit card provider
• How that law and others end up forcing many Americans into a lifelong debt, and cause those who are near the edge to fall off once something bad happens (like medical issues, debt, car accidents, etc.)
• How reservist military members had to file bankruptcy because their pay was cut when they were placed on active duty in Iraq for 23 months straight
• How inaccurate many consumer credit status databases are, and how Suze Orman has a deal with Fair Isaac
• How large banks are fueling the payday advance loan industry by infusing those companies with large sums of cash

You can watch preview clips on the Maxed Out Movie website.