Reasons Why a Loan Modification Still Makes Sense

by tammy on July 13, 2010

While mortgage loan modifications have always existed as an option, they really evolved into a major industry with the collapse of the American residential real estate market in 2008. The basic idea is that loan modification lowers the monthly mortgage payment for the borrower; thereby allow them to stay in their home. This is the sole purpose of a loan modification and it requires the voluntary consent of the lender, meaning that any proposed loan modification has to offer the lender a better deal than foreclosing on the property would. Even loan modification done through the federal Housing Affordable Modification Program (HAMP, part of the larger making Home Affordable initiative) requires the active consent and endorsement of the lender, so it is important to keep this in mind.

Finding the right balance between what the borrower can afford and the point where it becomes more profitable for the lender to foreclose and resell the property is the tricky part of the process. The general standard is that the borrower should not be spending more than thirty percent of their monthly gross income on their mortgage payment. People that are already spending a smaller percentage of their monthly gross – not net – income on their mortgage payments should not even waste their time asking for a loan modification since it will probably be rejected out of hand. At the same time, these monthly payments still have to be high enough to be in the lender’s interest, therefore if the borrower has a very low income and thirty percent of this amount is too small; then the lender is likely to reject loan modification out of hand. In view of this, it should be kept in mind that loan modification is realistically restricted to people that have significant regular income.

Assuming the borrower seems likely to qualify for a loan modification – he can show financial distress, he is paying more than thirty percent of his income in mortgage, and he has a regular income – the next step is to determine how the monthly payments will be reduced. Remember that the lender has to agree to the terms, so it is extremely rare to see a lender agree to reduce the actual amount owed or the applicable interest rate. Instead, the usually method of reducing the monthly payment is to simply extend the life of the loan, or the loan’s amortization period. By spreading the same amount owed over a longer period of time, the monthly payments go down without actually reducing the amount owed. Generally the upper limit for an extension period is ten years, though the actual extension is just to the point where the borrower’s monthly payment equals thirty percent of his income.

Loan modification still makes sense for borrowers that want to stay in their homes but are having difficulty maintaining their monthly payments. However, as the residential real estate market continues to improve, the willingness of lenders to accept loan modifications decreases. Today, the main people likely to receive a loan modification agreement are those that are willing to continue paying more than the actual property is worth, on the hope that at some point in the future the value is recover to its pre-2008 level.

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