Mortgage Modifications That Focus on Principal More Successful
A study from the Federal Reserve Bank of New York has shown that mortgage modifications that reduce the principal of a home loan are much more successful than those which just lower the payments.
This really does make sense for how the homeowners see the long term viability of remaining in the home. If most homeowners are like me, I look at my loan balance regularly. It would be disheartening to go through a loan modification and still see a balance that is significantly higher than the homes true value.
The incentive to repay the loan in that situation would be severely diminished. In fact, the fight or flight instinct would be activated, such that giving up ones credit rating and running for safety would be a logical move. However, if you got a principal reduction, you would see that there is a long term benefit of staying in the home and continuing to pay ones mortgage.
Simple psychology explains a great deal in the housing market. Too bad the powers that be in Washington can not figure this out. Instead they put in programs that sound great on the television but do not help or motivate the homeowners in real life.
The paper finds that principal reductions are more successful at avoiding re-defaults because they reduce negative equity and give the borrower a greater incentive to keep current on the loan. A loan modification that only reduces the interest rate, meanwhile, “creates an in-place subsidy to the borrower leading to a lock-in effect. That is, the borrower receives the subsidy only if he or she does not move.”
The paper takes a hypothetical borrower with a home that is worth around $30,000 less than the $200,000 mortgage on the home. In two different modification scenarios, the monthly payments are reduced by the same amount but produce different probabilities of re-default.
In a modification that reduces the borrower’s interest rate by 2.8 percentage points to lower monthly payments by 25%, the borrower’s probability of defaulting within one year is reduced by 11%.
But under an alternate modification that lowers monthly payments by 25% by reducing the borrower’s loan balance by 25% and through a slight interest rate reduction, the borrower’s probability of defaulting within one year is reduced by 26.5%.
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Comment by Bob on 5 January 2010:
I agree that lowering the principle is the ONLY way a loan mod will work. The homeowners do not feel good about a situation where there net worth has taken such a big hit. Hopefully these types of loan mods will become the norm.
Comment by Simon Salloom on 6 January 2010:
Good thing you have done here, Thanks!
Simon Salloom LA Times: Southern California home prices and sales improve in November
Southern California’s real estate industry, decimated by the mortgage meltdown and housing bust, is stirring to life again — even making hiring plans — as home prices bounce back.
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Comment by Oliver on 6 January 2010:
That’s an interesting thought.
But if they start lowering principal then wouldn’t everyone just start missing payments and request a loan modification? Then the banks would have to lower EVERYONE’s balance. Seems like an easy fix to a complicated problem, that in the long run would only get more complicated.
What do you think?
Oliver
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Comment by missoula physical therapist on 6 January 2010:
Makes complete sense to me, I have a friend who is upside down and way behind or her mortgage. She talks about walking from it and renting and being way ahead with money, if she still had any equity, she wouldn’t even consider walking away from the house.
Comment by Kirk Kinder on 6 January 2010:
If the bank takes the hit on the principal writedown, I don’t have a problem with this. If there is a move for taxpayers to pay for the principal writedown, I am totally against it. I don’t care if the re-default rate is lower. This would create a massive moral hazard.
How many people who can make payments but have negative equity would look for a principal paydown at the expense of the taxpayer. The numbers would be huge.
And, don’t fool yourselves. A large percentage of the 30% of homeowners with negative equity are not poor schmucks who got suckered into homes they can’t afford. Many are people who did not buy at the top of the market, but they refinanced several times to buy new cars, pay for lavish vacations, etc.
Just let the markets correct. As the prices have dropped, more buyers have re-entered the market. This is the only way to create a healthy market.
Comment by Portland Condo Auctions on 8 January 2010:
Makes perfect sense to me. You are only helping them in the short term, if their home does not go up in value then they dont have much incentive to stay.
-Tyler
Comment by Mike on 18 January 2010:
Kirk Kinder makes good points.
Bankers and politicians believe (incorrectly) homeowners value their homes and public perception.
They don’t!
In Florida, we face serious market distress with shadow inventory not disclosed in numbers used to (sound) better than they are.
Job losses continue!
On one hand, principal reduction is only valid solution to long-term housing stability.
On the other hand, principal reduction should result in more defaults as homeowners want their “slice of the pie” as well.
Unfortunately, Kirk, Florida (at least) cannot allow the market to correct on its own. Even an $8k (and $6500) “gift” cannot force all buyers off the fence.
Many buyers say their jobs are secure (whatever that means today) and they say they plan to stick around for 3-5 years.
Yet, these people are concerned about buying into a market experiencing continued value drops.
Perhaps Kirk is in a market not besieged by distressed properties or underwater values as I am in Sarasota and Orlando (and everywhere in between).
Allowing the market to correct on its own is HORRIBLE.
Mike