First way worked for me, and I didn't even have to burn a CD, or use a cd at all.
Basically Heres what I did. Pretty much 3 steps.
1. I converted all the mp3's i wanted as custom tracks to wav files. (theres a million programs out there that do this, you can even do it with winamp)
2. Opened up "Rockstar Custom Tracks" and dragged the wav files into the "Rockstar Custom Tracks" window (then it prompts to designate the folder where it will save). I closed Rockstar Custom Tracks after the wav files were done. 2b: i edited the filenames of the wav files. i removed .wav and replaced it with .gta instead. so song1.wav became sound1.gta (yah yah 3.5 steps but how hard is it to drag and drop..thats not even a step)
3 Connected the psp to the computer with the usb cable. (you have to turn the psp on and click on "USB connection" which is in the left list and the computer will recognize it has a removeable drive. I created a folder in the saved files directory called "ULUS10041CUSTOMTRACKS" and dragged all the gta files in.
Bang that was it.
Tuned the game on turned custom tracks on and jumped in the black 4 door whip wit da spoiler that i got a fresh new paint job on >=)