While many mortgage lenders have stepped up and streamlined their mortgage modification strategies, they still are reluctant to reduce borrowers' principal balances. This reluctance can be attributed to three factors:
- There is the reluctance to create "moral hazard" -- that is, to encourage mortgage delinquency in more homeowners by effectively rewarding those who default.
- The lenders have a legal duty to the loan's investors. Loan modifications, including principal reduction, are only allowable if the investors would lose less by writing down the loan than they would with another sort of modification or even foreclosure. To make this determination, lenders apply what is called a net present value (NPV) test. This has to be applied to every modification application.
- Making Home Affordable only allocates funds to aid lenders in defraying losses resulting from mortgage rate decreases, not principal reductions.
That said, some borrowers do manage to negotiate principal reductions. What factors determine whether a borrower is more likely to obtain a principal reduction as part of their loan modification?
Who Is Offered Principal Reduction, and How Can You Get It?
First, if you have a Countrywide mortgage, you could be in luck (and this might be the only time you feel lucky to have a Countrywide home loan!). If you have a pay option ARM or a subprime loan, you may qualify for a principal reduction of up to 95% of your home's current value. The catch? You have to have originated your home loan between January 1, 2004 and December 31, 2007 in one of the states that agreed to an $8.6 billion settlement with Countrywide (now Bank of America): Arizona, California, Connecticut, Florida, Illinois, Iowa, Michigan, North Carolina, Ohio, Texas or Washington. Tennessee, Mississippi and Pennsylvania also settled predatory lawsuits with Countrywide, so borrowers in those states may also be able to get principal reductions as well.
Negotiating with Your Lender
In states that don't allow mortgage lenders to sue borrowers for deficiency judgments (also called non-recourse states), you have more leverage. If you were to simply walk away from your mortgage and your home, your lender could end up much worse off than it would have if it proffered a reduction of your principal balance. Furthermore, you don't end up with a foreclosure on your credit report--that's worth some concession on your part as well. The Federal Reserve Bank of Richmond classifies Alaska, Arizona, California, Iowa, Minnesota, Montana, North Carolina (for purchase mortgages), North Dakota, Oregon, Washington and Wisconsin as non-recourse states. In other states, you can still protect yourself from a deficiency judgment by filing for bankruptcy protection. Putting that option on the table may make your lender a bit more receptive to reducing your principal balance.
Not Negotiating with Your Lender
There is still another alternative. It works like this: Hedge funds, banks and other investors purchase underwater loans from mortgage lenders at deep discounts. The banks get an 80% reimbursement through the Troubled Asset Relief Program (TARP). The investor writes the loan down to 90% of the property's value, and takes over your mortgage. There are no tax consequences to you, nor are there any credit report repercussions. Here's an example:
- A homeowner in Florida owes $300,000 on a house now worth $150,000.
- An investor purchases the note from the lender for $100,000 ($200,000 discount).
- The investor writes the loan down to $135,000 (instant profit of $35,000).
- The lender is reimbursed $160,000 (80% of $200,000), so it recovers a total of $260,000.
The program won't go on forever (the last TARP disbursement has taken place), and there are several catches. You have to be at least 25% underwater or the banks don't consider you risky enough to bother selling your loan cheaply. You need good credit and sufficient income (a debt-to-income ratio better than 50%) or the new investors don't want to lend to you. Lastly, you have to pay the new investor about $1,600 upfront. Some asset purchasers are legit, while others may not be. Research carefully before paying anything -- make sure the company is licensed in your state, check with the Better Business Bureau, your state's attorney general and business or financial institutions division.
Gina Pogol has been writing about mortgage and finance since 1994. In addition to a decade in mortgage lending, she has worked as a business credit systems consultant for Experian and as an accountant for Deloitte.