One of the aspects of mortgage lending that has changed the most in the wake of the housing bust is the down-payment. At the height of the boom, it looked like down-payments could soon become, well, if not extinct, than at least irrelevant. Nowadays, a sizable down-payment is not only essential to getting a loan with good terms, but also to getting approved for the loan in the first place.

The current benchmark for down-payment is 20% LTV. That means you are expected to pay 20% of the price of the property in cash, with the mortgage covering the remaining 80%. For those of you who can afford to make such a down-payment, statistics show that you will be comparatively likely to repay your mortgage. Thus, you can expect to receive extremely favorable terms on your mortgage.

The primary source of funds for this down-payment will probably be your own savings account. In some cases, you can also pledge securities (stocks, bonds, etc.) and the land that the property occupies assuming that you already own it. Lenders will also allow you to borrow against your retirement account (though in some cases this must first be approved by the administrator of your IRA) as well as to contribute gifted funds from family/friends, as long as the giver signs an affidavit pledging that the gift is not actually a loan.

If the target property was appraised for more than the purchase price, however, you cannot contribute the difference towards the down-payment, even though it is arguably equivalent to home equity. The only exception is if the seller is willing to raise the purchase price and contribute (most of) the difference to your down-payment for the loan. Such is perfectly legal and is known as a Seller-Assisted Down Payment. Bear in mind, however, that if the purchase price is raised to the point that it exceeds the appraised value of the property, this kind of arrangement will probably be rejected by your lender.

If you can afford to do so, you should consider making an even larger down-payment. Some lenders will compensate you by offering you an even more attractive mortgage rate. In addition, a larger down-payment combined with a shorter duration (i.e. 20 years instead of 30 years), would enable you to own your home in a shorter amount of time and save you money in the process (in the form of unpaid interest), all without affecting your monthly payment. If instead you were to continue to prefer a long-duration (30 years) mortgage, you can count on both a lower monthly payment and aggregate savings over the life of the mortgage.

For those borrowers that can’t afford – or simply don’t want – to make a 20% down-payment, you have a few options. First, you can apply to a Down Payment Assistance Program (DPAP); it’s advisable to ask your lender for advice, rather than solicit help on your own. If you’re eligible, you can consider a Veterans Administration (VA) loan, most of which don’t require down-payments. FHA Loans are also insured by (but not originated by) the government, and hence, require only 3.5% down-payments. This is offset by a more expensive loan, however, in the form a mortgage insurance premium, payable to the FHA to compensate for the increased likelihood of default.

For everyone else, you can expect to pay a hefty Private Mortgage Insurance (PMI) premium. Assuming your lender is still willing to underwrite your loan, despite a down payment that is below 20%, you will pay both an upfront PMI premium and an annual premium, until your home equity reaches 20% LTV. [Your home equity will gradually rise both as you repay the loan and if the value of the home appreciates].

Of course, the reality is slightly more nuanced. The actual importance of the down payment will depend on numerous other factors, including your credit score. In the end, you should first seek to understand the position of your lender before determining the size of the down-payment.

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.

A handful of recent studies have shown that borrowers tend to make lots of costly financial mistakes in the final stages of buying a home. Ironically, it is after the target property has already been identified that home-buyers start to commit serious lapses in judgement.

According to researchers, this phenomenon is known as cognitive resource depletion. “Shopping for a home and choosing between alternative features ‘can deplete individuals’ cognitive resources, resulting in sub-optimal home-financing decisions. After the shopping experience, consumers may devote less attention to the mortgage-choice process…relying on faulty-decision shortcuts that ‘ultimately result in a higher propensity’ to select higher-risk mortgage products.” They advise that after selecting a home, one wait at least a week before beginning the process of obtaining a mortgage.

A survey conducted by the Atlanta Federal Reserve Bank, meanwhile, found that people who aren’t as adept at math are naturally bad at budgeting for mortgage payments. “Even accounting for a host of differences between people—including attitudes to risk, income levels and credit scores—those who fell behind on their mortgages were noticeably less numerate than those who kept up with their payments in the same overall circumstances.” It’s unclear what implications this has for borrowers; should those bad at math avoid taking out mortgages in the first place?

This probably isn’t practical, and instead, borrowers should budget carefully, regardless of mathematical ability. That means prior to obtaining a mortgage, you should analyze your spending patterns and compare it to your after-tax income in order to determine what size mortgage you are eligible for. Many borrowers simply plug in wishful figures into Mortgage Calculators, in order to inflate the size of the loan that they think they can afford. In this case, it’s truly “Garbage In, Garbage Out,” which means the calculations are only as good as the inputted numbers. Do yourself a favor and take this exercise seriously. Also, be advised that, “Qualifying for a loan amount doesn’t mean that it is in your best financial interest to take on that much debt.”

Finally, there are a handful of financial considerations that don’t involve obtaining a mortgage, and are instead connected to the purchase price for a property. When negotiating such a price, remember that the transaction consists of more than simply assigning a value to the property. Even after agreeing on what the property is theoretically worth, you might still to extract savings by persuading the borrower to pay for certain repairs and housing fixtures, pay for your closing costs, pay you to delay your move-in date, and/or leave over some large appliances. In short, “Everything in a real-estate deal is open to negotiation, and sometimes price isn’t the most important factor.”

According to research, it was not subprime lending that that fomented the housing bubble and ultimately led to its collapse. Rather, it was home equity lending, especially of the cash-out variety. In short, borrowers took advantage of artificially low interested rates and inflated to extract cash, and in the process, lowered the equity balances in their homes. The Federal Reserve Bank summarized this phenomenon as follows: “The rise in the market value of homes since the early 1990s has led to a substantial increase in the level of housing wealth. However, since the mid-1980s, mortgage debt has grown more rapidly than home values, resulting in a decline in housing wealth as a share of the value of homes.”

In fact, Alan Greenspan, himself, estimated that “ four-fifths of the trifold increase in American households’ mortgage debt between 1990 and 2006 resulted from ‘discretionary extraction of home equity.’ ” In other words, most new mortgage debt was created as a result of refinancing (which increased the appraised value of the properties), rather than debt to fund purchases of new homes. “In 2005 alone, U.S. homeowners extracted a half-trillion-plus dollars from their real estate via home-equity loans and cash-out refinances. Some $263 billion of the proceeds went to consumer spending and to pay off other debts.”

The link between cash-out refinancing and foreclosure is surprisingly cut-and-dried: “For every 1 percentage point increase in its share of subprime mortgages that are cash-out refinances, the likelihood of foreclosure in that state goes up by one-third of a percent.” This connection is not difficult to comprehend since borrowers with less equity will necessarily have a more difficult  time repaying their mortgages, either for lack of wherewithal or lack of motivation (perhaps resulting from being underwater).

There are very clear lessons here. First, borrowers should exercise extreme caution when increasing the balance (via a refinancing) of their primary mortgage. This is true if the funds will be pumped back into the home, and especially true if the borrower intends to withdraw some of the proceeds, since this directly increases the likelihood of default.

From a policy standpoint, it’s clear that cash out refinancing should be heavily regulated, if not banned outright. Some experts have pointed to Texas, where the incidence of both foreclosures and underwater mortgages are well below the national averages. By no coincidence, “There, Cash-outs and home-equity loans can’t total more than 80 percent of a home’s appraised value. There’s a 12-day cooling-off period after an application, during which the borrower can pull out. And when a borrower refinances a mortgage, it’s illegal to get even $1 back.” Texas takes these rules so seriously that they are enshrined in the State Constitution.

It’s unlikely that the imminent federal overhaul, in all its glory and fecklessness, will include a similar provision. That’s unfortunate, since the data clearly shows that if a repeat housing bubble is to be avoided, the most effective measure might just be to ban cash-out refinancing.

There’s nothing that causes me greater irritation (or subsequently gives me greater pleasure) then reading blatantly erroneous financial advice in a major newspaper and then debunking it.

Recently, I read an article in the New York Times entitled “When Not To Pay Down A Mortgage,” in which the author, Ron Lieber, lays out the case for and against early repayment of your mortgage. He concludes that based on current interest rates and economic circumstances, it doesn’t make sense to repay it, because you can probably earn more investing your savings elsewhere. Still, he concedes that there is an emotional benefit to repaying your mortgage early and being debt-free.

Lieber makes some good points about how it’s clearly better to first pay off higher-interest debt, such is that associated with a credit card or home equity loan. Don’t be tempted to make extra mortgage payments in order to lower the duration of your mortgage without first paying down your credit card. He also urges readers that in the current economic climate, it’s very important to make sure that you have an adequate cash cushion in case of hardship, and that emergency funds clearly should not be used to prepay the mortgage regardless of your interest rate.

But here’s where Lieber goes astray. He repeats the classic mortgage fallacy which is that your real interest rate is less than your stated rate because of the mortgage interest tax deduction, which means that your hurdle rate (the rate of return that you would need to earn in order to make not prepaying viable) is much lower than you think. There is only some truth to this, but it depends on the type of investment account and the type of investment. If you use the funds (that you would have otherwise used to prepay your mortgage) to day trade, then you will be taxed on your earnings (or more likely your losses…) at your normal income tax rate, completely offsetting the interest tax deduction. The same is true if you invest using your Roth IRA, since you will necessarily have paid income taxes on all contributions to that account before they can be invested. Really, the only exception is that if you invest in stocks using your traditional IRA, you will be taxed at the long-term capital gains rate (15%), and can reap some benefit from the tax rate differential. Still, this assumes that (at current rates) you will need to average 4-5% a year simply to break even! Maybe you think that you can, but is the added risk really worth it? In this regard, the only way you really “beat the system” is if you contribute more funds to an employer matching 401K. Personally, I would have thought this was obvious, and that anyone with half a brain would have done this before prepaying their mortgage.

Lieber’s other argument is even more questionable: given how much housing prices have fallen, it doesn’t make sense to prepay your mortgage, because if you decide you want to walk away, it becomes even more costly. Of course, this is entirely true, but I have a hard time believing that a significant portion of borrowers obtain mortgages with the intention of breaking them when housing prices decline. I, too, am an advocate of walking away from your mortgage when it makes financial sense, but the idea of financial planning with this possibility in mind strikes me as ludicrous. Even in the current crisis, only a small minority of borrowers (~10%) will default on their mortgages. For those who are underwater, I’m sure that they regret every cent that they paid into their mortgage. But asking them to anticipate the position that they ultimately found themselves in and acting accordingly is unfair.

I think Lieber’s conclusions stand on their own. There is a strong emotional benefit to repaying your mortgage early, as long as you can afford it. While it’s possible that you will come out ahead by paying off your mortgage normally and investing in the interim, there is added risk and no guarantees associated with such a strategy.

You’re mortgage is underwater. What do you do?

A few years ago, this would have been a fringe question for a fringe audience. Nowadays, though, 25% of all residential mortgages are underwater. In states like Nevada and Florida – two of the epicenters of the housing bubble and subsequent bust – more than half of borrowers owe more on their mortgages than their homes are worth. In other words, for a growing portion of homeowners, this question is of foremost importance.

For argument’s sake, let’s assume that you have already discussed a loan modification with your lender, and you have been either rejected or presented with an inadequate offer. As a result, you have made the decision to part with your home. [Admittedly, this is a weighty decision]. Should you sell your home at a loss, or simply walk away from your mortgage and allow your lender to deal with the fallout?

The first option is known as a “short-sale,” since the proceeds from the sale of your home wouldn’t be enough to cover the balance of your underwater mortgage. Accordingly, a short sale (or its first cousin, the deed in lieu of foreclosure) first requires the approval of the lender, because it is tantamount to writing off part of the mortgage as a loss. Still, many lenders are amenable to this possibility, because it is often less complicated – and hence, less expensive – than outright foreclosure. You will also need to confer with any junior-lien lenders as well as the mortgage insurance company, if applicable. After receiving an offer on your home, this must then be submitted to the lender (via its loss mitigation department) for final approval.

Here are a few additional things to keep in mind: Minimizing the transaction costs of the sale (by hiring an expensive real estate agent, for example) will go a long way towards convincing the lender that the deal is worthwhile. Next, while a short-sale is less painful than a foreclosure, there will still be some inevitable damage to your credit. In addition, you might be expected to pay taxes on the portion of your mortgage that was forgiven by the bank. Finally, be advised that short sales typically take longer to complete than normal sales, as lenders will often spend a long time deliberating over whether to approve the deal.

If your house has depreciated too much in value, and/or your lender is not willing to approve a short-sale, then a strategic default might be your last option. So-called as to distinguish it from a “conventional” foreclosure, a strategic default is a voluntary decision to stop making mortgage payments despite the capacity to do so. While choosing foreclosure might strike some as oxymoronic, it turns out that for many, it is actually a perfectly rational choice. Simply, the negative impact on one’s credit score and the possibility of a deficiency judgment, pales for some when weighed against the prospect of spending the rest of one’s lifetime paying off a mortgage that is well underwater.

That’s because while foreclosure technically remains on one’s credit report for 7-10 years, it can become functionally irrelevant in the eyes of lenders in half that time. In addition, deficiency judgments (in which the lender sues to collect the difference between the value of the property at the time of foreclosure and the amount owed under the mortgage) are illegal in many states, and rare in the rest. That being the case, the only remaining consideration is the moral one- deliberately breaking a contract that you have the ability to honor. While there are strong arguments to be made for both sides, I don’t think this is an appropriate forum to explore that dimension, however. Let your conscience be your guide.

With an estimated 80% of those aged 55-64 carrying some time of debt, the question of whether to pay off a mortgage or take it into retirement looms large these days. I will attempt to shed some light on it below.

Prior to the credit crisis and the bursting of the stock market bubble, financial planners recommended mortgage borrowers to plow all extra cash into stocks and other assets, rather than paying down mortgage debt. The argument was grounded in “simple” arithmetic; assuming a mortgage rate of 5.5% and the 15%+ annualized returns that the stock market was averaging, mortgage borrowers could earn a healthy spread.

This logic was turned on its head as a result of the market crash, as the S&P initially lost 50% of its value. In hindsight, borrowers reckoned that they would have been smart to sell off some of their more liquid investments and use the proceeds to pay down their mortgage debt. Now that the market has rebounded – though not (yet) to the highs of 2008 – some are wondering whether the initial advice was right after all. Maybe the key is merely patience.

Personally, I side with the camp that encourages a debt-free retirement. Using your mortgage loan to fund stock and bond market speculation is hardly sensible, regardless of the potential upside. Some analysts counter that a diversified portfolio will outperform residential real estate over the long-term, so you are better off maximizing the leverage on your home and plowing the proceeds into other investments. Research has showed, however, that this is simply not the case, especially after taking taxes into account.

To be fair, such a strategy could be defensible for younger generations, who are understandably more keen to take bigger risks in search of bigger returns. For those in or near retirement, however, now is not the time to roll the dice. If your retirement savings are sufficient or are on pace to become sufficient, then why would you jeopardize that by keeping money in risky assets? If, on the other hand, your savings are inadequate, you would be advised to use what you have to pay down your mortgage, so that your debt burden is lower.

If your mortgage is so large that repaying it is simply unrealistic or impossible, perhaps you may want to consider downsizing into a less expensive house, with the goal of lowering your mortgage debt. “Converting” your mortgage debt into a reverse mortgage is also a possibility, though one that you should only consider as a last resort, due to its high up-front costs and the steady erosion of your home equity that it will wreck.

I realize that my analysis risks being labeled by critics as simplistic. Many have argued, and will continue to argue that the decision to repay your mortgage debt is a complex one, and must be weighed against many factors, such as the interest rate that you are currently paying, the return that you expect to achieve on your retirement account, and the proportion of your net worth that your mortgage represents. As implicit in my advice, however, I don’t think any of this analysis is necessary. No one knows how the stock market will perform over the next next 30 years, nor does anyone know how much (if at all) your home would appreciate. The question is: are you willing to bet your retirement on it?

Given that mortgage rates are at record lows, many borrowers are urgently wonder whether they should execute a mortgage rate-lock. With this post, I will try to provide some clarity on this question.

Let’s begin with the basics. As implied by its name, a rate-lock is an agreement between borrower and lender that literally locks in a mortgage rate at a certain (most likely the current) level. Such an agreement will generally specify an interest rate, discount/origination points, and an expiration date. [As an aside, locking in an interest rate is not the same as being approved for a loan. According to the Federal Reserve, "A lock-in is not the same as a loan commitment, although some loan commitments may contain a lock-in. A loan commitment is the lender’s promise to make you a loan in a specific amount at some future time."]

Historically, lenders required legally binding commitments from borrowers before they would issue a rate lock. Nowadays, this practice is less common, since lenders have come to perceive that it puts them at a competitive disadvantage. As a result, lenders compensate for the possibility that a) interest rates will rise and/or b) the borrower will renege on the rate lock, by charging a small premium to execute the rate-lock. Most rate locks expire within 30-60 days; while longer time periods can be negotiated, you can generally expect to pay a higher premium for a rate lock that expires later.

There are a few things to keep in mind with a rate-lock. First, the agreement should always be in writing, since oral agreements would be possible to prove, if need be. Second, you should always make sue to lock the points as well as the interest rate; failure to do so would enable the lender to compensate for a rise in interest rates by charging more points, without violating the rate-lock agreement. In addition, try to approximate (with the help of the lender) when your loan can realistically be closed so that you select an appropriate time period of validity. On your end, make sure you do everything necessary to close the loan before the rate-lock expires. Finally, make sure you read the fine print. Some rate-lock agreements contain clauses that render the whole contract void under certain circumstances, while other lenders slip in language which allows them to charge a higher rate than initially agreed-upon, as long as it doesn’t exceed a certain cap.

By this point, you’re probably wondering: What’s the point of a rate-lock, anyway? While certainly you can successfully go through the process of obtaining a loan without bothering to lock in the rate ahead of time, it certain makes the process much smoother. Knowing the interest rate ahead of time allows you to calculate your exact monthly mortgage payment, and confirm that it falls within your budget. It also makes a very stressful process (obtaining a mortgage) that much less stressful, since you don’t have to worry about whether rates will change prior to closing.

As to whether a rate-lock is right for you, that’s a question that only you can answer. No one can predict interest rates, which means it’s equally impossible to predict whether an interest rate-lock will ultimately prove to be a wise decision. Consider, however, that interest rates are currently at record lows. While they could certainly drift even lower, the conservative assumption is that they can only go up from here. If even a slight uptick in mortgage rates would jeopardize your ability to close on the loan, a rate-lock would be a safe choice. If, on the other hand, you have a cushion built in, not locking won’t do any harm, but could leave you feeling stresses until your loan closes. For those of you who are somewhere in between, consider a rate-lock agreement with a “float-down” option, which protects you against rising rates while also giving you some of the upside from lower rates. While you will have to pay a premium for this additional feature, at least you won’t be kicking yourself if you signed an agreement and rates plummet.