Underwater Homes to Benefit From New Mortgage Modification Plan

Online, May 20, 2010 (Newswire.com) - Banks could lower interest rates, extend mortgage terms, or restructure loans, but writing off part of what the borrower owed wasn't exactly a recourse. However, changes in President Obama's mortgage modification program may make principal reductions a possibility, particularly for those with underwater mortgages.

A mortgage is considered underwater when the home's value is lower than what is owed on the loan. This has become fairly common in recent years as home values dropped and many homeowners were left in sub-prime loans that were just reverting to regular rates. Because there isn't enough equity in the home to refinance, the only alternative to foreclosure in such cases was a short sale, which did not let the borrower keep his home.

Principal reductions directly slash off a certain amount from the mortgage balance so that it better matches what the home is currently worth. Understandably, lenders were mostly unwilling to grant them because they represent a direct loss and may render the mortgage contract non-binding. This is why the government is working to produce more incentive for lenders to grant principal reductions and help troubled homeowners avoid foreclosure.

An estimated 11 million homeowners, making up 20% of borrowers nationwide, are believed to be underwater. The new mortgage modification program will aim to help these borrowers, which economists consider to be most at risk of foreclosure. Some also believe it will keep many of them from simply walking away from their loans, a trick known as "strategic default," rather than try to regain equity over the next several years.

A borrower will be eligible for the principal reduction plan if he or she keeps up with mortgage payments over a set period. Officials will compare the performance of these borrowers with those who got more conventional mortgage loss mitigation plans, such as interest rate reductions, term extensions, and interest-only payments. This will allow them to see whether reducing the principal can actually keep underwater loans current.

FDIC Chair Sheila Bair calls the basis of the plan "earned principal forgiveness," meaning a borrower has to maintain a certain standing under his or her mortgage modification plan in order to get the reduction. She added that it would be limited to homeowners who were significantly underwater, as those who are not in serious default or at risk of foreclosure could benefit from less drastic mortgage loss mitigation methods.

The new mortgage modification program is not the first to propose principal reductions or address the negative equity problem, causing some experts to doubt how well it can work. A previous project called Hope for Homeowners also urged lenders to forgive part of the principal for underwater borrowers, but failed to take off. A proposal to let bankruptcy judges order principal reductions also get turned down in the Senate last year.

However, lenders appear to be showing more support for principal reductions in recent months. Reports from the Office of the Comptroller of the Currency show that in mid-2009, 13% of mortgage modification cases were principal reductions, up from only 10% the previous quarter. Major banks, headed by Wells Fargo, have also started putting into effect various programs to help underwater borrowers through principal reductions.