Ask Liz Weston

Dear Liz: My son lives in an area where the real estate market took a major hit. His first and second mortgages total $320,000. The value of his home is now $180,000 to $200,000. He has a good job but is having trouble making ends meet. He can’t refinance, although if he could this would save him hundreds of dollars.

He is 34 and has talked about just walking away. His credit score is around 800, and he pays all his bills.

If he walks away, how long would it take him to reestablish his credit to buy another home? He has talked to his bank, but for the bank to help, he would have to have lost his job. Please provide advice on what he needs to do. He is getting frustrated living check to check.

Answer: This seems to be Concerned Parent Day.

Your son should first check with a housing counselor approved by the U.S. Department of Housing and Urban Development to make sure he understands all his options. He can find one at www.hud.gov.

A foreclosure or short sale (selling the home for less than what he owes, with the bank’s permission) would trash his credit scores, but with otherwise responsible credit behavior, he could begin rebuilding his credit to near-prime levels within a few years.

He could get another mortgage from a conventional lender two years after a short sale and five years after a foreclosure. He could get a mortgage from the Federal Housing Administration two years after a foreclosure.

Once he understands his options, he’ll still have to make a decision about whether he’s comfortable walking away from this debt. Many people believe they have a moral obligation to pay a mortgage if they possibly can.

Dear Liz: I’m a Realtor with a client who has a 719 credit score. If we could get that score one point higher, he could save $5,000 on his home loan. His score was 45 points higher four months ago, and the only change was that one lender pulled his credit a month ago. Can we dispute the huge drop given that nothing else happened? What else can he try?

Answer: It’s extremely unlikely that one inquiry dropped his score by 45 points. Chances are something else changed on his credit reports. Check the balances and credit limits his credit card issuers are reporting. Any narrowing of the gap between the two (such as higher balances or lower limits) could have contributed to the sudden drop.

You can’t really dispute a credit score drop, but if incorrect information is being reported by his lenders, you can dispute that.

In any case, he should be able to boost his score by getting those balances down, preferably below 10% of his credit limits. Even if he pays his balances in full every month, he needs to be concerned about his credit utilization, since the balances reported to the credit bureaus are typically the balances on his last statements.

Dear Liz: We refinanced our house in January for a 30-year fixed rate of 4.625%. We are paying about $513 a month extra toward the principal, which will allow us to pay off our mortgage in 16 years.

We have 20-year term life insurance policies to cover the mortgage in case the worst happens to either of us. Both my husband and I contribute to our 403(b) retirement accounts at work.

However, we don’t have any emergency cash fund in our banks. We figured we can always borrow from our 403(b) accounts. We both have good credit scores (above 750). We have no debt besides our mortgage.

Any financial advisors out there would tell us to invest that $513 a month into mutual funds or stock because of all the good reasons that I’m sure you know better than us.

However, this is how my calculation works: We’d be saving about $100,000 interest if we pay the mortgage loan off in 16 years. On top of that, we won’t have to make any payment for the remaining 14 years, which would be almost $200,000. The total saving is about $300,000.

Is there any mutual fund out there that can yield that much money if we decided to invest in it? Is it a good idea to do what we are doing right now based on our financial situation?

Answer: Actually, $513 a month invested in a mutual fund would result in about $765,000 after 30 years, assuming an average annual return of 8% (which is the minimum investors have received in every 30-year investing period since 1928, according to Ibbotson Associates).

Even if you look just at the 16-year repayment period, investing the money would recoup about twice what you expect to save in interest.

Now, you could probably build a substantial nest egg if, as soon as you paid off the mortgage in Year 16, you started investing your mortgage payment plus the extra $513. But you’d never make up the ground lost by not investing the monthly $513 from the start.

Also, you need to consider more than potential investment returns when deciding to prepay a mortgage. You have to look at your entire financial picture and make sure all your bases are covered before you pay off a low-rate, potentially tax-deductible debt.

Your lack of an emergency fund is worrisome. Yes, you can tap your retirement funds, but those loans could become taxable, permanent withdrawals if you lose your jobs and can’t pay the money back.

It’s far better to have cash in the bank to cover the unexpected expenses and financial setbacks that life can present.

You should have, at a minimum, an emergency fund equal to three months’ worth of basic expenses before you consider prepaying your mortgage. A fund equal to six months’ worth of expenses is even better.

Since you’re a homeowner, you also should set aside a separate, sizable amount to cover major home repairs — $2,000 at least, although $5,000 is better.

If, like millions of others, you can’t afford your mortgage payments and are getting the run-around from your loan servicer, you may be considering whether or not to walk away from your home.

Before you decide, you need to read Stephen Elias’ book “The Foreclosure Survival Guide.” It’s published by Nolo, the self-help legal publisher, and is the best guide I’ve found for dealing with this nightmarish prospect.

It’s well worth the $16 you’ll spend to buy it at Nolo or Amazon. But now it’s available absolutely free on Nolo’s Web site. You don’t get a physical book or a download, but you can browse every single page on the site.

Dear Liz: When does it make sense to refinance a home? I have a 30-year, fixed-rate jumbo loan. The loan is just over 2 years old with a rate of 6.5%. Should I refinance to 5.75% with zero points? I make extra payments every month with the intention of paying the loan off in 15 years, but I don’t want to be locked into a 15-year rate in case I have some difficult times.

Answer: There are no hard-and-fast rules about when to refinance. When refinancing costs were higher, you typically needed a 2-point drop in rates for a new loan to make sense, but that’s no longer true.

Generally, though, you should avoid refinancing if the new loan wouldn’t recoup its costs within two years. Although the loan you’re considering doesn’t charge “points” — a percentage of the loan paid to lower the interest rate — you’ll still be charged other fees. If the lower payments would offset those fees within 24 months, and you plan to stay in the house at least that long, you might consider replacing the loan.

Another factor to consider is how much longer you’ll remain in debt with a new loan and how close you are to retirement. Ideally, you’ll want to be mortgage-free by the time you quit work.

When you’re just a few years into your loan, as you are, this is less an issue than if you’ve paid down your mortgage for five or more years. In the latter case, you should either consider opting for a shorter loan — 15 or 20 years, say — or make extra payments on a 30-year loan if you otherwise wouldn’t pay off the mortgage by the time you’re ready to retire.

Dear Liz: We’re refinancing our mortgage and home equity loan and will be paying about $200 less per month. Would we be better off applying this extra money toward the mortgage so we can pay it off in less than 15 years? Or would it be better to put it into savings or invest it?

Answer: Most people have better things to do with their money than pay off a low-rate, tax-deductible debt such as a mortgage — especially if you’re already on the road to paying it off in 15 years.

You should first make sure you’re on track with your retirement plan. If you’re not already getting the full company match from your 401(k) or 403(b), that extra $200 could win you an instant 25% to 100% return, depending on the generosity of the company match.

Even if your plan doesn’t have a match, you could get a tax deduction on your retirement contributions that you won’t get paying down the principal on your mortgage. Plus, your money is likely to earn greater returns over time than what you’d net by paying off your loan early.

If you’re maxed out on saving in your workplace plan, consider contributing to a Roth IRA. If you’re on track for retirement, paying off other debt and bolstering your emergency fund would be the next smart moves. Once that’s done, review your insurance coverage to make sure you’re adequately protected on the life, disability and long-term-care fronts.

Only after you’ve got all your financial bases covered should you consider accelerating your mortgage payments.Don

Dear Liz: I began paying down my debt six months ago and have paid off $10,000 so far. I subscribed to a credit score tracking system through a free offer and was told my credit score was in the 670 range most of the time. When I applied for a mortgage loan recently, however, the bank told me my middle score was only 612. One credit bureau said my score was just 590! How is this possible?

Answer: There are many different credit scoring formulas available today, but the one used by most mortgage lenders is the FICO. You have FICO scores from each of the three bureaus, and mortgage lenders typically use the middle of those three scores to determine your rates and terms.

Unfortunately, many of the companies hawking “alternative” scores don’t make it clear to their customers that they’re not seeing a FICO score. The confusion is compounded by the fact that your credit scores, including your FICOs, change all the time, and lenders also use somewhat different versions of the FICO scoring formula, which can produce somewhat different results.

Still, for a score that’s closest to what your lender will see and use, you want FICOs. You can buy your FICO scores for two of the three bureaus at MyFico.com. Unfortunately, Experian no longer sells FICO scores to consumers, although it continues to sell them to lenders. That means you can no longer know in advance what rate you qualify for, since you can’t know what your middle score is until your lender gets all three.

photo credit: Mike Licht, NotionsCapital.com

Credit expert John Ulzheimer reports a disturbing development: a decision by the credit reporting industry to report loan modifications as “partial payment plans.”

From John’s blog:

The issue at hand is how very large mortgage lenders, namely Citigroup, Chase, and Bank of America, may report mortgage loan modifications to the credit reporting agencies and, secondly, how that credit reporting impacts the consumers’ FICO® credit scores. According to the Consumer Data Industry Association, the credit bureaus have agreed to guidelines that loan modifications will be reported as a “Partial Payment Plan.”

The problem with this decision is that FICO credit scores interpret the notation of a “Partial Payment Plan” as negative. Consumers will see their scores decrease some amount of points because of such a classification. How much their scores decrease will depend on from where their scores started.

John notes that modifications typically involve a reduction of interest rates, not balances owed, and are often temporary. Since the lender is not losing any principal, it’s hard to imagine how the “partial payment plan” notation is justified

To read his full blog post, CLICK HERE.

Dear Liz: I seem to be in a “Catch-22″ situation. My mortgage refinancing was about to close when the lender backed out because I live in a geodesic dome home and there are no comparable sales for domes in my area. I’ve tried to find another lender but none will finance a dome because there are no similar homes to gauge the value. I feel that I am being discriminated against because my house has a rounded roof over part of it, instead of a flat or peaked roof. My broker suggested that I get a reverse mortgage since this does not require comps. However, I do not want to go down that road. Do you have any ideas of what I can do to refinance, now that I’ve lost the low rate I was locked into?

Answer: In the real estate boom, lenders stopped worrying so much about little niceties like accurate appraisals. With the credit crunch, lenders are suddenly obsessed with appraisals, which typically require comparable sales.

“The problem with this is that there is no way to come up with a realistic estimate of value for properties with unusual construction type because there are rarely comparable sales,” said Dick Lepre, a senior loan officer at RPM Mortgage.  “This includes domes, log homes and straw bale construction.”

What you need to find, Lepre said, is a local bank that intends to hang on to the mortgage, rather than sell it to investors. These lenders tend to be more flexible, but there’s no guarantee you’ll be able to find one willing to refinance your loan.

Your situation should serve as a warning to anyone who’s considering buying an unusual home, Lepre said.

“Anyone purchasing a home with any of these construction types should understand that mortgages are and will always be difficult and [that] it is a lot harder to find buyers,” Lepre said. “It is harder to find buyers because there are a limited number of people who want to live in such homes and also because it is harder for those buyers to find financing.”

Dear Liz: I have tried to work with my bank to modify my mortgage loan for the last six months. I send it every piece of paperwork it requests, but nothing is done. I bought my home for $280,000 and it’s now worth $110,000. My payments are very high and I’m getting depressed.

Answer: Contact a housing counselor approved by the U.S. Department of Housing and Urban Development. You can find links at www.hud.gov. This free counselor can review your situation and help you deal with your bank.

You may need to face the possibility that a loan modification may not help. Sometimes to create an affordable payment, lenders would have to reduce the amount you owe, which few are willing to do. Even if you do get a payment you can afford, you probably will owe more than your house is worth for many, many years to come.

To help you sort through these issues, read the Nolo book “The Foreclosure Survival Guide: Keep Your House or Walk Away With Money in Your Pocket” by attorney Stephen Elias.