A loan modification is a change in the loan contract agreed to by the lender and the borrower. The modifications of major concern today are those designed to reduce the payment burden on borrowers faced with impending rate increases that will make the mortgage payment unaffordable to them. Many are sub-prime borrowers. Homeowners faced with this prospect, whether they are already delinquent or not, should request a modification. They are very unlikely to get one if they don�t ask, and the stakes are very high: they can save their house and their credit.

Mortgage Loan Modifications
October 7, 2007, Revised December 7, 2008, April 21, 2009

Mortgage modifications are changes in the terms of a mortgage loan designed to make it more affordable to the borrower. Generally, modifications are available only to borrowers in default, or in imminent danger of default from  impending rate increases that will make the mortgage payment unaffordable to them. The purpose is to cure or avoid the default, thereby avoiding foreclosure.

Homeowners in or faced by default should request a modification. They are very unlikely to get one if they don’t ask, and the stakes are very high: they can save their house, though probably not their credit.

The Default Requirement

Viewed from the standpoint of the investor, the requirement that to be eligible for a modification a borrower must be in default, or in imminent danger of default, make good sense. If a loan will pay off on schedule without a modification, there is no reason for the investor to bear the cost of a modification. The financial rationale of a modification is that, without it, the loan will go to foreclosure, and this will cost the investor more than the modification. The best indicator of whether or not a loan will foreclose without a modification is whether or not it is now in default.

Viewed from the standpoint of the borrower, the default requirement is patently unfair, and it is. But much of what happens during a financial crisis is unfair. The default requirement is an unavoidable fact of life, and borrowers have to deal with it the best way they can. 

Note: About 5 months after the first version of this articled was written, the Federal Government attempted to moderate the inequity associated with the practice of limiting modifications to borrowers in default. The Making Home Affordable program establishes a “hardship” criteria for eligibility that does not require the borrower to be in default. See The Administration’s Plan to Help Troubled Borrowers.

 The Lender’s Modification Decision

In most cases, the decision on a modification is not made by the firm that owns the loan. It is made by a firm servicing the loan under contract to the owner. The owner could be a single lender, or it could be a group of investors who own pieces of a mortgage-backed security collateralized by a pool of loans.

Whoever the owner, the servicing firm is contractually obligated to find the solution to payment problems that will minimize loss to the owner. If the lowest-cost solution is a contract modification, great, everyone involved prefers a modification to a foreclosure. But if a foreclosure would generate lower costs for the owner, the decision will be to foreclose. The cost of foreclosure to the borrower does not enter the decision.

Yet the decision is far from cut and dried, and it can be materially affected by whether and how the borrower presents his case. On this issue, I have benefited from an exchange with Warren Brasch, an attorney who represents borrowers seeking loan modifications (wbrasch@gmail.com).

The Importance of the Homeowner’s Equity

Perhaps the most important factor affecting the modification decision is the amount of equity the borrower has in his property. If the borrower has enough equity in the property to pay any deferred interest plus foreclosure expenses, foreclosure is almost bound to be the lower-cost solution.

Equity depends on property value, which the borrower is much better positioned to know than the servicer. The borrower knows or can easily find out how many houses in the neighborhood are for sale, and what the trend has been in recent sale prices. In a weakening market, it is easy for the lender to over-estimate value and the borrower must prevent that.

On December 3, 2008 when this article was revised, the task of convincing lenders that the borrower had no equity had become much easier because of the continued decline in home prices. Almost all borrowers looking for a modification had negative equity. But other barriers to modification had also arisen. Read Foreclosures That Shouldn't Happen But Do.

The Burden of Proof Is On the Borrower

Servicers fear that if they are liberal in granting modifications, borrowers who don’t need a modification will seek one anyway. They protect themselves against this by entertaining modification proposals on a case-by-case basis, while placing the burden of proof on the borrower.

Borrowers must accept the burden of proof. In addition to the data on property value, they need to document that they cannot afford the payment increase that is pending, and they must document exactly what they can afford.

For this purpose, borrowers should calculate their total debt ratio: the sum of mortgage payment, other debt payments, property taxes, and homeowners insurance as a percent of their gross (before tax) income. This number should be calculated now, what it will be after the rate adjustment, and what they will be able to afford. On the last, Brasch suggests that a servicer may be willing to accept 45% as a reasonable maximum. That is pretty high, FDIC in modifying loans held by banks it has taken over, uses 38%.

Borrowers Must Be Persistent

Servicers have a self-interest in minimizing modifications because they add to costs. They try to minimize costs by computerizing the servicing process to the maximum degree possible, and standardizing customer support procedures so that low-paid and easily-trained employees can perform them.

Modifications must be handled by a special group who are more highly trained and better paid, and the increased costs from expanding their number cuts into the bottom line. Hence, there is a tendency to be non-responsive in the hope that the borrower will go away.

Borrowers have to be persistent. According to Brasch "If a servicer says they will call you back…forget about it. You need to call them and call them constantly. They will lose your paper-work, fail to return calls, put you on hold and then hang up. Its what they do. Keep fighting, calling, faxing. This does work!"

Inserting Future Price Appreciation Into the Equation

Note: Since the approach recommended below has never been implemented, borrowers who need a modification and who want to with what is rather than what might be, can skip this section. 

In making their decisions about whether a modification would be less costly than a foreclosure, servicers usually ignore an asset possessed by the borrower that could tilt the balance toward modification. This is the right to future appreciation in the value of the borrower’s house. In exchange for a modification that might otherwise be more costly to the owner than a foreclosure, the borrower could pledge a percent of the future appreciation, which could shift the balance to modification.

To make the decision process easier, I have designed a new calculator, numbered 7e, Unaffordable Payments: Trading a Payment Subsidy For a Share of Appreciation. The calculator compares the cost of a subsidy provided under a contract modification to the estimated value of a share of the appreciation, over any future period up to 10 years. Because costs are incurred monthly while appreciation is realized at the end of a period, all figures are translated into present values to make them comparable.

An Example Using the Calculator

For example, in 2005, John Subprime took out a 2-year adjustable rate mortgage for $100,000 at 5%. It was a 100% loan, but the balance had been paid down to $97,237. The initial payment of $537 was affordable, but lasts only two years.

The interest rate will be reset in two months to equal the value of the rate index, currently 5%, plus a margin of 3%. If the index stays where it is now, the rate will go to 8%, and the payment to $724. John cannot afford this payment.

Calculating the Payment Subsidy: Using the formula developed above, John convinces the servicer that he can afford no more than $580 a month for the next 3 years. The modification keeps the rate at 5% and adjusts the payment to $580. Over 3 years, the difference between the affordable payment and the scheduled payments with an 8% rate sums to $5190, which at 6% has a present value of $4337. This is the cost of the payment subsidy to the owner of the mortgage.

Calculating the Balance Subsidy: In addition to the payment subsidy, there is a balance subsidy because keeping the loan at 5% allows a more rapid pay-down of the balance. The subsidy is equal to the difference between what the balance would have been at the end of the contract period had there been no modification, and what it will be with the modification.

Over the three years, the balance subsidy amounts to $3670 with a present value of $3067. The present value of the payment and balance subsidies combined is $7404. This is the cost of contract modification to the investor without an offset from appreciation.

Net Cost of Foreclosure: The net cost of foreclosure to the investor is the estimated expense of foreclosure less the equity in the borrower’s house, which is available to offset foreclosure expenses. Equity is the difference between the estimated proceeds from a foreclosure sale and the mortgage balance.

If net foreclosure costs in my example are $5,000, this is lower than the $7404 cost of modification, and the servicer will opt for foreclosure. But factoring a share of future appreciation into the equation can change the result.

Net Cost of Foreclosure With Appreciation Factored In: Suppose the servicer estimates that John’s house may increase in value by 2%, 3% and 4% over the next 3 years. On these assumptions, the appreciation will be $9262, with a present value of $7740. Using this number, a 50% share of the appreciation would reduce the net cost of modification to $3534, which is lower than the cost of foreclosure.

Concluding Comment

Borrowers with payment problems who have a lot of equity in their homes have the most to gain from pledging a share in future appreciation. Such borrowers are otherwise unlikely to qualify for a contract modification because foreclosure will be less costly to the investor.

Borrowers in trouble, however, can’t assume that the servicer will take the initiative in proposing any modification deal, let alone a more complex variety that includes a pledge of future appreciation. The culture of loan servicing discourages such initiatives because they raise costs and do not generate any additional revenue.

Troubled borrowers with the best chances of negotiating a contract modification are those who are persistent, and who provide the information required to support their case. If they have significant equity in their home, this should include a proposal to share future appreciation with the investor, including reasonable estimates of what that might be worth. The more of the servicer’s job they do, the better their chances of success. See The A, B, Cs of Getting Your Mortgage Modified.

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