Loan modification basics

Loan modification overview

There have been a lot of comments and questions lately about loan modifications. When I first began to offer loan modifications to my clients, I wanted to make sure they knew how the process worked from both sides. There are two sides to any transaction and knowing about both sides keeps expectations in check when renegotiating an existing mortgage.

Briefly, loan modifications are a renegotiation of an existing loan on a property. It is a compromise between the lender and the borrower where they work together to find a solution to one or more issues that if not resolved may force the homeowner to default on the loan or force the lender to begin foreclosure proceedings.

Modifications are simple transactions that work because two motivated parties work out a mutually beneficial compromise.
For example here is a story about Linda Lender and Homer Homeowner.

In 2007, Linda Lender decides to loan Homer Homeowner $300,000.00 at 8% interest so he can buy a home. The loan is secured by Homer’s house, then worth $380,000.00. And everybody is happy.

In 2009, Homer Homeowner decides to refinance his home because he wants to lower his interest rate and his monthly payment. He looks at the plummeting property values in his neighborhood and realizes that his home is no longer worth what he bought it for two years ago. Now he realizes his home is worth $100,000.00. Homer has a problem with this. He realizes he cannot qualify for a new loan because he owes Linda Lender $300,000.00 and his property is only worth $100,000.00—he is upside down on his mortgage. In addition to being upside down on his mortgage, Homer’s wife is laid off from work and now the Homeowners are struggling to make their monthly mortgage payment.

Linda Lender notices that the Homeowner’s monthly payment is showing up later and later every month. Because Linda and Homer have an agreement that he will make his payment on time, or the loan will go into default, she pays close attention to when his payment arrives. Homer continues to be late with his monthly payments and then misses two mortgage payments in a row.

Linda looks at her balance sheet and sees that the collateral that secures her original loan (Homer’s house) should be worth at least $380,000.00. Thinking that she can easily recoup her original investment by selling off Homer’s house Linda begins foreclosure proceedings. Linda only wants to get back what she is owed so she will be able to make another loan with the money she lent Homer.

The last thing Linda wants is to take possession of Homer’s house. Even if property values in Homer’s neighborhood had stayed the same Linda knows she will probably take a loss on her investment is she forecloses on Homer. If she cannot sell the house and get her money back out to lend to other people she will not make a good return on her investment. If Linda does take possession of Homer’s house, it will be a big expense for her until she sells it and gets her money back. It is not a smart move for Linda to foreclose on Homer’s house unless she has no other option.

Homer gets his notice of default and after considering his options—short sale of his home to pay off as much as he can of the mortgage or bankruptcy—he decides to try and modify his mortgage. Homer knows that, in California at least, Linda must make a comprehensive attempt at modifying his existing loan before she can legally foreclose on the property.

Homer begins the modification process and after going over his income and liabilities comes up with a new total monthly mortgage payment (total monthly mortgage payments include principal, interest, taxes and insurance) based upon 31% of his monthly income. For example’s sake let us say this new payment is $1200 per month. Homer brings this information to Linda and asks her to modify his existing loan.

The moment Linda Lender receives Homer’s request to modify his existing loan she looks over his application and sees the proposed new monthly payment of $1200. Linda then does a NPV (net present value) calculation on Homer’s house. A NPV calculation is done by taking the proposed payment amount and calculating it out over 30 years ($1200 X 12 X 30 = $430,000.00). If she discovers that the proposed new payment of $1200 per month is worth more than she can get for immediately foreclosing on Homer’s home and selling it at auction (probably $90,000.00) she will decide to do the modification—it makes sense for Linda to modify Homer’s loan.

Linda drops the foreclosure proceedings and begins to modify Homer’s existing loan to fit the new payment of $1200 per month. The first thing Linda tries is dropping the interest rate (in some cases as low as 2%--the floor for interest rates as determined by the Treasury Department guidelines for loan modifications). If dropping the interest rate fails to lower Homer’s payment to the $1200 proposed monthly payment, then Linda Lender will begin dropping the amount of principal owed on the existing loan. Using a combination of lower interest rates, principal reduction, and recapitalization of missed payments (adding missed payments to the principal balance) to get Homer’s loan current, Linda comes up with a new loan that fits Homer’s proposed payment and still makes her money in the long term.

This is a very simplified version of the modification process from both sides. Lenders really do NPV calculations when determining whether to foreclose on a property or modify an existing loan. Borrowers really must document all their liabilities and monthly income to come up with a proposed mortgage that reflects 31% of their monthly income. 31% is the magic number when determining a new monthly payment.

If a homeowner chooses to do a loan modification on their own, the smartest thing to do is research your lender’s guidelines to ensure that the application fits with that lender’s guidelines for loan modification. A denial from a lender does not mean that they will not modify an existing loan it usually means the application did not fit within their guidelines.

Those who would rather have a professional loan modification company process the application for them should know that there cannot be any upfront money charged before the modification is approved. Reputable loan modification companies only charge after they have gotten an approval from the lender that they will do the loan modification.

Want to know what points are? Want to know about 1031 exchanges? Want to know if you have to pay a real estate agents commission when you buy or sell? Want to know how mortgage brokers can offer a “no points no fee loan”? Want to know why you need title insurance? I love answering your questions about loans, real estate, and any other question you may have about the industry.

Shoot me an email with your questions and I will do my best to answer them in my column. Please send questions to america@vgrouprm.com. I’ll do my best to answer.