Why is this happening? That’s what I wanted to know. So I reached out to Craig Watts, my go-to source at Fair Isaac, the company that calculates the FICO score. The problem, Watts says, is that these loan modifications are fairly new, and there was some confusion about how lenders should report them to the three national credit bureaus. The calculation of your FICO score is an intricate process, and relies on a series of codes that are used to represent the actions you take that will affect your score. When you open a credit card, the lender reports that using a code. When you close a card, the lender uses a different code. These loan modifications, on the other hand, didn’t have a code yet. So the industry got together and decided to redefine an existing code, one that is also used to report a partial payment by a credit card borrower, an act that is seen as negative by the credit bureaus.

Still with me? In a nutshell, when your lender uses this code to report a mortgage modification, FICO – and other credit scoring systems – are factoring it into your score as a negative. Thus, your score drops. How far it drops actually depends on how high it was in the first place.

“it depends on what else is on the credit report, but it’s possible that a score could drop by 100 points. For someone who has a relatively high score, where this code could be the first big negative, this could cause the score to drop significantly. For someone who already has delinquencies, their score wouldn’t fall as far,” explains Watts.

The problem should be fixed in November. The industry has already agreed on a new code, but it takes some time to implement it across the board. Until that happens, there isn’t a whole lot consumers can do, unfortunately. Lenders have to report your loan modification, and as long as the information they report is accurate, and you agreed to the modified mortgage, you don’t have a place to challenge it. But here’s my advice – if you can’t make the payments, you’re already falling behind, and your score is likely already in trouble, I’d go forward with the modification. But if you’ve been keeping up with your payments so far, and you can hold out a few more months, you may want to weigh the possibility that your interest rates will go up against the fact that your credit score will go down.

-B., Alabama

If you’re looking for a lower interest rate on your loan, you can refinance or go through the loan modification process-which I warn you, can be a long and complicated one. The route you take will ultimately depend on your financial circumstances.

To determine which option is right for you, visit the government’s Making Home Affordable website. There you’ll find two separate questionnaires that will show you if you qualify for either refinancing or loan modification.

Let’s take a look at refinancing first. If you’ve taken the refinancing quiz in the past few weeks or months, you’ll notice that question four-which asks whether or not the amount you own on your first mortgage is the same or less than the current value of your house-has changed. Now, as the question indicates, you can be as far as 125% underwater on your loan and still qualify for refinancing. Until just recently, that number was only 105%. If your quiz results indicate that you may be eligible for refinancing, gather up your paperwork, call your loan servicer or lender and start talking about your options.

Think that loan modification might work for you? Run through the site’s quiz to be sure. The topic you asked about-hardship-is addressed in question three. As you’ll find out by taking the quiz, hardship is a necessary element to qualifying for modification. Something must have happened (job loss, a cut in overtime, an injury, etc.) that has impacted your income between the time you got your mortgage and now. If the quiz says you’re eligible, fill out the hardship affidavit, gather your necessary materials and begin negotiations with your loan servicer or lender.

If you’re in trouble with your mortgage, or you see yourself having difficulties in the future call a HUD approved housing counselor. Make an appointment and then sit down with them to determine which option is best for you. One final note: You should never be paying anyone to modify your mortgage. The only person who can guarantee a modification is your lender or the servicer of your loan

If this describes you — and judging by the piece in the New York Times over the weekend that noted only tens of thousands (not hundreds of thousands or millions as expected) of loans had been modified and made affordable, you MUST keep trying.  The banks, the lenders, were unprepared to deal with this in terms of the manpower they have on their sides.  They are attempting to get through the paperwork they have on their desks.  They are just swamped.

I am not excusing them.  I am just telling YOU what is happening behind the scenes.   Call again today.  Then again tomorrow.  And while you’re at it, get a counselor from the Hope Now Alliance — call 1 (800) 225-5342 — to call with you and for you.  And keep on trying.

Yes, that is correct.  The site outlines the stipulations to make you eligible to apply for a loan modification from your lender; however, the program is voluntary and there is a chance your servicer isn’t participating (many are, though – and there are financial incentives for them to do so.  You can find a frequently-updated list of servicers who have signed on here.)

If your servicer is participating, they will then put your loan through a series of tests to determine if you qualify.  This includes:

•  Determining whether your loan is eligible (owner occupied, originated on or before January 1, 2009, unpaid principal balance equal to or less than $729,750).  

• Asking about your current income, assets and expenses as well as why you are unable to make your current mortgage payment (you’ll need to provide proof – tax returns, pay stubs). 

• Determining if your monthly mortgage payment is more than 31% of your monthly take home pay.  

• Adding past due charges (interest, but not late fees) to the loan balance. 

• Calculating how much they would need to reduce your interest rate in order to get your mortgage payment to under 31% of your monthly take home pay

•  Seeing if the cost of the modification (including the government’s incentive payments to the servicer) is less costly for the investor than not modifying the loan (Note: If you have a lot of equity or your income is very low compared to the value of your home, you will likely not pass this test)

• Putting you on a modification for a three-month trial at the new payment amount to see if you can make the payments.  If you are successful,  you’ll receive a permanent modification agreement that will lower your interest rate to a fixed rate for five years, and then cap it at a low rate for the remainder of the loan. 

Under that plan – which you can read about at www.makinghomeaffordable.gov – you do NOT have to be behind on your mortgage payments to be eligible for a loan modification – but you do have to be at risk of imminent default. That means either your mortgage payment has increased and you can no longer afford it, your income has been reduced pretty significantly, or you’re experiencing some other kind of hardship – a medical emergency, for example. If this is you, you should contact your mortgage servicer – again – and let them know what’s going on right away, keeping in mind that you’re going to need to document your income and expenses and provide evidence of your change in financial circumstances. Tell them that you think you qualify for a loan modification under the Making Home Affordable plan. They will then be able to run the numbers for you.

The exact qualifications for the Making Home Affordable Modification are:

You must be an owner-occupant in a one to four unit property,

You must have an unpaid principal balance that is equal to or less than $729,750 for one unit properties (there is a higher limit for two to four unit properties – consult your servicer)

Your loan originated on or before January 1, 2009,

Your mortgage payment (including taxes, insurance, and home owners association dues) is more than 31% of your gross (pre-tax) monthly income

Your mortgage payment is not affordable, perhaps because of a change in income or payment amount.

Yesterday, I was a guest on Carmen Wong Ulrich’s CNBC Show On The Money.   Ric Edelman was there as well — he has a new book out — and the fabulous Tyler Mathieson (the publicist at Money magazine where we both once worked described him as “the light of our lives.”)  Ric and I — as we have in the past — butted heads on the idea of paying down a mortgage.  We had a question from a viewer who wanted to know if he should pay off his second mortgage (8.75% or therabouts) or put the money toward savings or investments.  He was already shoveling money into his retirement plans so I said pay off the second, get rid of PMI, that’ll give you more to sock away.  Ric disagreed.  He’ll have to fill you in on why.

But let me just explain what got me started on our overwhelming debt problem to begin with.  It was an article by Louis Uchitelle years ago on the front page of the New York Times that pointed out we Americans owned a smaller share — a smaller equity — in our homes than we had at any time since the 1960s.  I started researching and we not only owned less of our homes, but our cars and we were carrying more in credit card debt and student loan debt than ever before.  This information was the foundation for Pay It Down.  And the situation as you know didn’t get better.  It got a whole lot worse.

The advice that says because mortgage debt is cheap you should have a lot of it, take the tax deduction, and invest the money you’re not putting toward that mortgage may seem to make mathematical sense.   It does often make mathematical sense.  That doesn’t mean it works.

It doesn’t work when — as people did during the last decade — you decide you’d rather spend the money than invest it.

And it doesn’t work when the market doesn’t go up during your time horizon.

Now — say the naysayers — what if the value of the home went down?  Why should you work to pay it off then?  Because barring a real hardship — like a job loss or an illness — the President’s housing plan isn’t going to help you get away with not repaying your loan.  Because if you can truly afford to make your payments the bank isn’t going to come to the table for a short sale.  I know what it feels like to have bought a home at the wrong time because I did it.  Does May 2005 ring a bell?

But I also know from research I’ve conducted over the years that having debt makes you unhappy.  It makes you unable to sleep at night.  It stresses you out.   Particularly when your income is going down — i.e. for most people in retirement.  Which is why by the time I stop working, and I hope, long before, I will have retired this mortgage of mine. If I need to access this debt to pay for part of college or something else, I know it’ll be there.  But I won’t have to worry about having a place to put my head at night.

P.S. Both Ric Edelman and I will be on CNN with Gerri Willis this coming weekend.  I’m looking forward to round 2.