In light of these statistics, it’s not surprising that more and more borrowers are simply walking away from their mortgages, despite the fact that many have the financial wherewithal to continue making payments. According to Experian, a credit rating agency, 582,000 such borrowers executed a “strategic foreclosure” in 2008 alone, which is more than twice as high as the 2007 total.

In other words, a growing contingent of borrowers has determined that it’s simply not economical to continue paying their mortgages. (As an aside, this is an excellent indication that homeowners, themselves, don’t have much confidence in the apparent housing recovery that many analysts believe is taking shape). Before, it was assumed that the impact of foreclosure on one’s credit would be enough to discourage strategic default, but the uptick in this trend demonstrates otherwise. Some borrowers evidently think it will be too many years before housing prices will return to the bubble levels. For those that bought properties for speculative purposes, there is a sense that it makes little sense to continue making payments on an investment that has little value.

Despite the clearly negative impact of this phenomenon for lenders, they appear to be doing little to avert it. Some are finally helping borrowers with loan modifications, but this rarely involves a truncation of the principal amount. Thus, borrowers who were underwater before receiving a modification will likely remain underwater after a modification, despite the lower monthly payment.

The government, for its part, hasn’t done much either. Its program aimed at helping underwater borrowers reduce their debt burdens through refinancing has been a miserable failure, reaching only 3% of eligible borrowers, despite the recent elimination of an initial 5% cap on underwater equity. It seems that despite the possibility of a lower interest rates, most borrowers are smart enough to realize that paying money (i.e. closing costs associated with the refinancing) to retain an underwater mortgage doesn’t make financial sense. Ironically, the Mortgage Forgiveness Debt Relief Act of 2007 is facilitating strategic default by allowing borrowers to discharge of debt tax-free. [If not for the law's passage, foreclosure could have potential tax consequences].

Still, there are negative consequences of ignoring government help and deliberately defaulting on a mortgage. For the majority of Americans, foreclosure is still stigmatized. From a financial standpoint, foreclosure (as well as short sales and deeds in lieu of foreclosure) will immediately result in a lower credit rating, diminished ability to borrow, and higher interest rates. Thanks to the Mortgage Forgiveness Debt Relief Act, strategic default no longer carries any tax implications. Of course, they may be costs associated with finding a new residence.

From a legal perspective, one’s liability post-foreclosure depends one’s state of residence. 10 states forbid banks from making claims against personal assets when foreclosing on a mortgage with negative equity. The other states, however, generally allow lenders to sue for the difference. Legal experts have indicated, however, that this is only used in 15% of cases, which means the majority of defaulters get off with hardly a slap on the wrist. Still, if you’re considering this as an option, it would be beneficial to consult a lawyer and/or accountant just to confirm.

Personal finance columnists usually advise a down-payment of 20% Loan-to-Value (LTV). In other words, take the size of your mortgage, multiple it by 20%, and VOILA, you have your down-payment. According to their reasoning, 20% is substantial enough both to demonstrate your creditworthiness to the lender and to cushion you from negative price swings in the value of your home.

Given the decline in housing prices, however, it’s perfectly conceivable that borrowers that made 20% down-payments are still underwater in their mortgages. After a foreclosure, then, such borrowers will be left with stains on their respective credit report, and gaping holes in their personal assets. From the lender’s perspective, meanwhile, such borrowers are actually considered less credit-worthy than those that make the minimum required down-payment. For those of you scratching your heads: It turns out that those who make down-payments between 20-25% are actually more likely to default. In addition, such borrowers aren’t required to purchase private mortgage insurance, further increasing the cost of default to the lender.

The cost of private insurance, then, can actually be recouped in the form of lower interest rates! In other words, there isn’t much of a financial penalty (sometimes even a reward!) for making a smaller down-payment. Some financial planners now encourage making the smallest allowable down-payment, based on the reasoning that borrowers can then set aside extra money in an emergency fund, making it less likely that they will become delinquent (miss payments) on their mortgage further down the road.

What is the minimum down-payment? Well, that depends on the loan, and the lender. A Federal Housing Administration (FHA) loan requires a 3.5% down-payment. [However, proposed legislation would increase this to 5%]. For veterans, or those that live in rural areas, there are VA home loans and Guaranteed Rural Development loans, respectively.

For those not eligible for the loans above, it might be worth looking into a down-payment assistance program. Some of these programs are also government sponsored, and/or provide low-interest loans to be used exclusively for making a down-payment. There are also several not-for-profit companies which offer down-payment assistance, typically by rolling the down-payment into the overall loan amount, but such organizations have come under scrutiny in the wake of the collapse of the housing market. For first time home-buyers, the $8,000 tax credit can now be “monetized” and applied towards the down-payment. [Under earlier rules, the credit was received in the form of a tax credit, and hence, could not used for a down-payment.]

For those still struggling to scrape together the cash, there are a few more options available to you. First, you can talk to your lender and try to pledge securities in lieu of making a down-payment, but be advised that such is tantamount to borrowing money to buy stock. Second, if you already own the land that your home is (being) built on, that may qualify as a down-payment. Third, you can appeal to family/friends for help, but be aware that the lender will demand proof that any such assistance is a gift, rather than a loan. Finally, you might try talking to the seller, and asking him to help you make your down payment (offset in the form of a higher sale price). This will only be possible, however, if the sale price initially exceeded the appraised value.

All else being equal, a larger down-payment should translate into smaller monthly payments, as a result of both lower principal and interest. It should also lower your mortgage insurance premiums. As I noted above, however, some lenders actually penalize those who make larger down-payments. Ultimately, every situation is different, and it probably makes sense to use a mortgage calculator to crunch the numbers associated with a few different scenarios to see ultimately which one makes the most (financial) sense for you.

It’s quite clear that something has to be done. A new report by the Mortgage Bankers Association (MBA) recommends that the two companies be split into three smaller entities and continue to perform the same role that they do now. Under the proposal, the new firms would bear all of the direct risk from owning/underwriting mortgages, but would still enjoy some form of government guarantee. It’s not clear how this structure would facilitate stability, though it would probably increase transparency.

An unrelated report by the Government Accountability Office (GAO) examines the three options for Fannie and Freddie without actually offering an opinion as to which one is most advantageous. It is quite critical of the MBA proposal, arguing that “Creating ‘reconstituted’ for-profit government-sponsored enterprises, either publicly traded or owned by lenders, ‘could lead to even greater moral hazard. ‘ ” The alternatives – elimination, privatization, or full government takeover – however, are equally fraught with complications. Without Fannie and Freddie, it’s unclear how the mortgage markets would function, while a government takeover would probably result in a downsizing of their lending portfolios.

Before I continue, I want to stop and explain the role that Fannie and Freddie play in mortgage lending. Namely, the two firms act as liquidity providers, by using shareholders’ equity to purchase huge portfolios of securities mortgages (Mortgage-Backed Securities). And when I say huge, I mean it: “The companies, which own or guarantee about $5.4 trillion in U.S. residential debt and have accounted for about 70 percent of all new home loans this year.” By acting as the largest buyers, they enable mortgage lenders at the ground level to originate new loans, confident that they can be quickly repackaged and sold.

At this point, it seems the most likely scenario is that which was proposed by the MBA. It’s hard to understand how this represents a solution, but I guess it’s like the old joke about democracy: “It’s the worst system, except for all the others.” In other words, Fannie and Freddie have become the fulcrums of the mortgage lending industry, so their disappearance would be accompanied by a massive decline in new mortgage origination.

There are certainly analysts and policymakers that would argue this is a desirable outcome. The government has no business – explicitly or implicitly – playing with mortgages. If the government formally exited the mortgage lending industry (except to serve as regulator), it would probably lead to better risk management, since investors would have to assume the full risk of owning mortgage backed securities.

In addition, some of the slack caused by their disappearance would probably be picked up by private investors, since a portion of the capital currently invested in Fannie/Freddie would presumably be diverted to firms with similar interests. At the very least, it seems lending standards would tighten and interest rates would rise, but both of these phenomena have already started to obtain.

From the standpoint of current mortgagers, this won’t affect you much. Refinancing could prove more complicated, but it wouldn’t affect the terms of your current loan. For potential borrowers, it would most likely make it both more difficult and more expensive to obtain a mortgage. It’s tempting for me to urge you to preemptively go take out a mortgage lest the system changed tomorrow, but this is extremely unlikely, as the GAO estimates ” ‘potentially lengthy transition’ given their size.”

In other words, don’t let this affect your decision one way or another.

Many lenders take advantage of (borrower misunderstanding of) points in order to make it look like their interest rates are lower than their competitors, when in fact the difference can be explained entirely by the points. On the surface, paying points would seem like a great option, since mortgage affordability is generally calculated backwards, using monthly payment – rather than the size of the mortgage – as a starting point.

In this way, the numbers can be manipulated, such as to make it so a potential borrower can afford a larger mortgage simply by extracting an upfront payment in exchange for a lower monthly payment. Of course, this can also be achieved by simply increasing the size of one’s down-payment, but yields slightly different savings. Generally speaking, a higher down-payment is more economical in the short term, while using points to buy down the rate is only beneficial over the long-term.

So, how can you go about calculating whether it makes sense to pay points? This Points Calculator makes this question easy. Simply plug in the loan amount, points, interest rate, interest rate with points, loan term, and a realistic return on investment, and the calculator will quickly generate a break-even point- the amount of time it will take before you can achieve positive savings on your mortgage.

In other words, the points system inherently favors the bank over the short-term. It’s impossible to achieve savings from Day 1. Instead, you must plan on living in your home (and keeping your current mortgage) for a certain number of years before paying points becomes worthwhile. If you have every reason to believe that you will stay in your home longer than the break-even period, then it makes sense to pay points. Instead, if you plan on refinancing or “trading up” before the break-even period, it probably makes more sense to simply increase the size of your down-payment.

Another consideration is whether to roll the points into your mortgage, in order to avoid making a large up-front payment. This will significantly extend the break-even period and is only economical if your savings rate (i.e. expected return on investment) is higher than your mortgage rates, and your marginal tax rate is low. The latter is a factor because financing your points allow the tax benefit to be amortized over the life of the mortgage, while an upfront payment can only be deducted in the year in which it is paid.

Finally, it’s possible to temporarily buy-down your mortgage payment, such that you pay a lower rate for only a few years. The 2/1 buy-down and 3/2/1 buy-down are the most common and straightforward, with the latter reducing your interest rate by 3% in the first year, 2% in the second, and only 1% in the third year, before reverting to the stated rate. Typically, you shouldn’t expect to achieve savings from a temporary buy-down; rather the perceived benefit is that you can delay the normal payment for a couple years, giving your income a chance to catch-up.

In terms of proof of assets, you should begin by compiling information on all of your bank accounts, including account numbers, the branch address(es), and copies of recent statements. Remember to include information for both checking and savings accounts. You should also plan on furnishing statements of other liquid assets, such as IRA retirement accounts, CD’s, annuities, and estimated cash value of life insurance policies. It wouldn’t hurt to provide valuations for Illiquid assets (real estate, valuables).

The next step is to document your income. This is best achieved through the provision of pay stubs, W-2 withholding forms, and even recent tax returns. If you are self-employed, you should prepare audited income statements for your business. Generally, lenders won’t require more than two years worth of data, but in some cases, they may request additional information.

Even if your creditworthiness has been established (and especially if it isn’t), it wouldn’t hurt to show timely payment of rent and utilities for the last 1-2 years. Your lender will also need to see and legal documents/filings (related to divorce, etc.) in order to determine if any potential liabilities exist.

Prior to the bursting of the housing bubble, it was possible to obtain a competitively-priced loan without providing any or all of the documentation listed above. Reacting to lending standards that were perhaps overly stringent, lenders gradually loosened their requirements. This led to lender complacency and the consequent proliferation of so-called liar-loans, which describe mortgages that require little or no documentation.

In some cases, it is still possible to obtain such loans. Some lenders will accept stated income and/or assets (as opposed to verified income and assets), but you can expect the spread to full documentation loans to be higher than before. According to a recent report, “Less-documented borrowers who reported high incomes were far likelier to default than those whose high incomes were verified – suggestion that loans were made on misleading information.” The report found that applicants were likely to overstate income by 20% on average when verification wasn’t required.

For some applicants, namely those who are self-employed or in-between jobs, a low-documentation loan might still be the best choice. No-ratio loans, whereby income and assets are verified but not used to calculate typical do-not-exceed ratios, might be necessary for those who want to purchase houses that are technically unaffordable.

Of course, you should speak to a loan officer before deciding whether a low-documentation loan is appropriate for you, but it helps to know your options before going in.

It turns out that advice is now being echoed by more and more people, who are insisting that universal home ownership was never economically viable, and not entirely desirable. In a recent Wall Street Journal Op-ed, one historian notes that renting used to be the norm, and buying/owning was the exception: “From 1900…through 1940, fewer than half of all Americans owned their own homes…But from that point on forward (with the exception of the 1980s, when interest rates were staggeringly high), the percentage of Americans living in owner-occupied homes marched steadily upward. Today more than two-thirds of Americans own their own homes.” He points out further that what ultimately catalyzed the change was not a change in culture/values, but rather a shift in government policy: “It wasn’t until government stepped into the housing market, during that extraordinary moment of the Great Depression, that tenancy began its long downward spiral.”

Over the past 50 years and accelerating over the last decade, this policy assumed a grotesque form. An increase in federal housing programs/subsidies/guarantees combined with easy credit to make home ownership easier to achieve, and hence more prevalent. The results speak for themselves: “The collapse of the for-sale housing market has left many low-income people holding mortgages they can no longer afford, becoming victims of skyrocketing foreclosure rates.” Meanwhile, homeowners began to see their homes as vehicles for investment, rather than for their inherent utility. The diagnosis is clear, according to the WSJ: “It’s time to accept that home ownership is not a realistic goal for many people and to curtail the enormous government programs fueling this ambition.”

As if on cue, the Obama administration is springing into action. It recently announced the allocation of more than $4 Billion in stimulus funds to the Department of Housing and Urban Development, with the goal of mitigating the growing shortage of affordable rental housing. “The idea is to pay for the construction of low-rise rental apartment buildings and town houses, as well as the purchase of foreclosed homes that can be refurbished and rented to low- and moderate-income families at affordable rates.” Politicians are also jumping on board, some claiming cynically that they always opposed the Bush plan to expand home ownership. “I’ve always said the American dream should be a home – not homeownership,” said Representative Barney Frank, for example.

In any event, this could be the start of a huge shift in preferences. Ironically, lenders are facilitating this shift by tightening lending standards and making it more difficult for potential borrowers to secure mortgages. Personal finance columnists also appear to be on-board, advising their readers to invest their savings in traditional vehicles, rather than in the dream of home-ownership. Could this be the start of a return to the days when “holding a mortgage came with a stigma?”

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.

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.

But what they forgot to tell you is that while the Federal Reserve has recently slashed the funds rate by 1.25%, 30 year fixed mortgage rates are going up:

U.S. fixed-rate mortgages rose in the latest week, according to Freddie Mac’s survey released Thursday. The national average interest rate on the benchmark 30-year, fixed-rate loan averaged 6.04% in the week ending Thursday, up from 5.72% a week ago, but lower than the year-ago 6.22%.

Home owners who get a mortgage today are paying for the money banks lost writing bad loans in the recent housing bubble.

If you are in a market where prices are dropping, expect further savings by waiting out your purchase, as homes keep losing value, inventory keeps increasing, and mortgage rates eventually reflect the Fed’s recent cuts and future cuts.