Foreclosure Re-default Drops by 26.5 When Loan Modifications Reduce Loan Balance

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The problem with loan modifications is re-defaulting. Well, that is only one of many problems with loan modifications but it is certainly one of the most annoying ones for lenders and the Obama administration. This is because loan modifications cost money. They cost money, they take time and this is a complete waste if the borrower re-defaults shortly after completing a loan modification.

That is why the government is interested in finding out what kind of loan modifications are less likely to re-default. The Federal Reserve Bank of New York carried out a new study that analyzed the success rate and re-default rates of different loan modifications.

The study reveals that when loan modifications reduce the principal, or write down loan balances re-default rates drop by half.

Loan modifications come in a variety of shapes and flavors. The main purpose of loan modifications is to reduce the monthly payments so that borrowers can afford them. Not surprisingly the most successful loan modifications are those that reduce loan modifications by the most. However there is more than one way to skin a cat and the same goes for loan modifications. Monthly payments can be reduced by reducing the interest rate, lengthening the term or rolling the interest to the end of the loan and of course the bank can write off part of the loan.

The above mentioned report showed that how the monthly payments were reduced affected re-defaulting rates. For example the findings showed that when a modification reduced the borrower’s interest rate by 2.8 percent and reduced monthly payments by 25% probability of re-default is reduced by 11%.

However when loan modifications reduced monthly payments by the same 25% by reducing the loan balance and through a slight interest rate reduction re-defaults drop by 26.5%.

This could have important implications for the government in its efforts to help troubled borrowers from losing their homes. The government is willing to invest money in incentives and programs to support loan modifications if this report is correct the money might be best spent for all involved reducing loan balances than lining lenders’ pockets.

Why does reducing loan balances reduce re-default rates?

The answer seems to be that many borrowers re-default on their loan modifications because their homes are so underwater there is little incentive in throwing good money after bad towards a mortgage that is worth more than the house it is paying.

However when lenders reduce the balance of a loan this increases the prospect that house price appreciation might bring the borrower out from underwater and back into positive equity. This provides extra incentive to the borrower that sees financial benefits in continuing to pay the mortgage despite it being underwater. If this study proves to be true it might be profitable for lenders to write off portions of a loan as part of a loan modification while maintaining interest rates or only reducing them slightly.

Both reducing interest rates and reducing the loan principal costs lenders money the important question is which option is most cost effective in the long run.