Do Loan Modifications Make Things Worse By Increasing Principal Balance

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The debate in the last months has centered on how the Government and lenders were not doing enough to get troubled borrowers into a loan modification. However, a recent report might indicate that this has actually a good thing for borrowers!

A report released last week by the State Foreclosure Prevention Working Group disclosed that about 72 percent of the loan modifications carried out in October ended up owing more. This is because lenders will add missed mortgage payments with interest to the modified loan. Therefore, although loan modifications may reduce monthly payments they sink borrowers further into debt.

This does seem an oxymoron, to help troubled borrowers by increasing the size of their loan. Supporters of the scheme say that this is necessary evil for lenders to be able to afford the modifications and allow borrowers to afford their mortgage payments and keep their homes. But is this even true?

Reports show that the number of borrower that foreclose after completing a mortgage modification is much higher when their mortgage balance was increased or left unchanged. This is because borrowers have little incentive in staying with a house that is worth less than their mortgage. If this is the case they will often simply walk away from their mortgage with means considerable costs for lenders.

This is called the underwater effect. Borrowers that own homes that are worth less than their mortgages have little hope to regain equity and are seen by their owners as a liability instead of an investment. Studies show that the best way to reduce foreclosure rates, a nuisance for both borrower and lenders is to reduce, even if only a little, the principal balance of the loan.

But is it the government’s job to force lenders reduce the principal of loans?

This is of course the big debate. On one side you will have those that feel most borrowers had it coming. “I knew I couldn’t afford it, so I kept on renting. Why should they get bailed out for borrowing irresponsibly?” seems to be a common opinion. The logic of the argument is hard to fault.

On the other hand there is the moral argument that the Government has a responsibility towards troubled families that could end on the street, which from a pragmatic point of view might even cost society more in handouts.

The other question is why even try and stop foreclosures? Many view them as a natural outcome of a financial crisis and that the market will normalize itself after going through the “normal” post crisis period.

Many feel that the best move underwater borrowers can make is to simply walk away from their mortgages. When asked about the morality of breaking the mortgage contract most will say banks had it coming when they started lending irresponsibly.

If your mortgage is underwater this is a good question to ask yourself. Is it really worth it for you to stay with your mortgage? Or would it make more sense to simply walk away, take the hit on your credit score and carry on with your life? The answer will depend on how much you have invested in your home, financially and emotionally.