I spent hours trying to figure this out and it turns out it was the "two-step verification" that was causing the problem. Once I disabled that feature through my hotmail account using a web browser, I was able to connect my mail to my iPhone easily.
Follow these steps:
1. sign on to your hotmail account using a web browser at www.hotmail.com
2. click on your name in the top right hand corner and select "Account Settings"
3. click the "Security & Privacy" tab
4. click "More security settings"
5. scroll down to Two-Step Verification and disable it
Now you should be able to sign into your mail account using your regular hotmail password.
*If you have installed an "Identity Verification App" that requires a password (different from your email password), then try using that password to connect your mail account to your iPhone. If you cannot remember it, or are unsure if you have installed a Identity Verification App, then follow steps 1-4 and scroll down to the Identity Verification Apps section and check to see if anything has been installed and disable as needed.
This link has more information:
http://http://www.askvg.com/fix-mail-apps-and-devices-shows-incorrect-password-e rror-after-enabling-2-step-verification-in-microsoft-or-gmail-account/