Most loan modification programs focus on making payments affordable for the short term instead of reducing the borrower’s principal to eliminate the burden of negative equity (when what is owed on the house is more than its value).
What is a Loan Modification?
According to HUD, a loan modification "is a permanent change in one or more of the terms of a mortgagor's loan, allows the loan to be reinstated, and results in a payment the homeowner can afford."
Loan modifications can lower monthly payments by extending the loan term, or by reducing the interest rate or the mortgage’s outstanding balance, or by a combination of practices.
Banks may reduce payments using gimmicks similar to sub-prime loans, such as ARM and temporary rate reductions that defer principal (ex. setting new adjustable rates for two years). Such rate reductions will lead to balloon payments in as little as two years as interest rates reset. Moreover, salaries and property values would have to double in that time to make the new adjustments affordable.
Meanwhile, homeowners making payments on the loan modification will be unable to refinance the mortgage or sell the home because too much is owed.
Should the home need to be sold because of life changes (job loss, transfer, illness, divorce), borrowers will find themselves unable to sell (unless they sell via short sale) because what is owed on the house is more than what the market will pay.
Borrowers will be trapped in prison of debt, and go further into foreclosure.
The Loan Modification Trap
Cutting the amount of principal owed –– an option that could be of more help to borrowers –– is rare because it means homeowners pay less money back to the bank over time. Banks have to write off the principle reduction amount immediately.
The government recently launched its “Making Home Affordable” program to stabilize the housing market by incentivizing banks to approve loan modifications. The program focuses on making loans affordable through lower interest rates, but delinquent amounts and late fees are typically tacked onto the mortgage balance. “Making Home Affordable” does not compel lenders to reduce mortgage balances.
Between 65%-75% of modified mortgages may re-default after 12 months, according to a new report from Fitch Ratings (May 2009). The U.S. Office of Thrift Supervision is more optimistic, but still predicts that 41%-46% of the 1.6 million mortgage modifications completed since 2007 will eventually fail.
In a recent study, the average reduction in payments for June was $173.
Overall, there is scant evidence of effectiveness concerning the ability of loan modifications to keep borrowers in their homes. The evidence does suggest that most homeowners that receive a loan modification will go into foreclosure at some point during the next 12 months.
Why is the Failure Rate So High?
First, traditional modifications only add the delinquent payment to the unpaid principal without changing other terms of the loan. The amount of debt increases and often results in higher monthly payments. This type of modification is likely to lead to higher re-default risks in the long run, especially when higher debt burdens are accompanied by declining house prices.
Second, most modifications do not bring mortgage debt in line with declining home values or reduce mortgage payments to an affordable or sustainable level.
To bring debt into line with declining home values, lenders need to reduce the principal owed so that the home is affordable for the long term. Few lenders are willing to do this because it reduces the income they receive from borrowers.
Third, a high debt burden (credit cards), increased unemployment and a decline in property values continue to add to the growing default rates.
Costs associated with applying for a loan modification may range from $1500 - $4500 if using an attorney or consultant.
Applicants may get hit two ways: To show that they can make the loan mod payments, they submit financials that look too good and the bank increases payments (31%). Other applicants have such weak financials, that the bank will not consider them for a loan modification because of doubts that they can pay. It’s a narrow window, and no one but the bank knows what the gap really is.
The main strategy behind loan modifications and workouts is to convert loans into option ARMs, with low teaser rates, and extend to 40-year mortgages: This is the same stuff that caused the housing meltdown.
With bankruptcies skyrocketing many of these loan modifications and workouts are converting people to renters and locking in the bubble price of the home.