Allowing homeowners to reduce their monthly mortgage payments can
significantly lower the rate of defaults compared to loan modifications that do
not reduce payments, according to a new study of recently modified loans
conducted by the University of North Carolina at Chapel Hill’s Center for
Community Capital.
Further, combining lower payments with a write-down of the loan balances
for loans that exceed the value of the home can prevent even more defaults.
“Our data clearly show that not all loan modifications are created equal,”
says center director Roberto Quercia. “By using such data to inform policy and
practice, the industry can reduce foreclosures and increase stability in the
economy.”
The study, “Loan Modifications and Redefault Risk: An Examination of
Short-Term Impact,” analyzed 10,000 loans that were modified to prevent default.
These modified loans came from a pool of more than 1.3 million mostly subprime
and adjustable-rate mortgages made during the peak of the mortgage boom, from
2005-2006.
The results show that the type of modification matters. Six months after
receiving a modification, homeowners who got a “traditional modification” --
where past due amounts and fees are added to the loan and the payment rises --
had a 60 percent higher rate of delinquency than those whose modification led to
a reduced payment. A full third of delinquent borrowers in the sample received a
modfication that increased their payments. “This is like throwing a
brick to a drowning man,” says Quercia.
Digging deeper to take into account the risk profile of each loan
before it was modified, researchers confirmed these trends: homeowners who
obtained a rate reduction were about 13 percent less likely to redefault than
similar borrowers in similar situations (e.g., type of loan, geography,
servicer, loan amount, etc.) who received a traditional modification. Those
whose rate reduction was accompanied by a principal reduction were 19 percent
less likely to redefault.
These findings come at a time when 12 percent of all loans (nearly 6
million mortgages) are past due or in foreclosure and 20 percent of all homes in
America are “underwater,” meaning their mortgaged property is worth less than
the amount they owe on their loan.
Policymakers at present are encouraging servicers to reduce monthly
payments as a percentage of household income by subsidizing lenders that reduce
payments to 31 percent of household income. These plans rely more heavily
on interest-rate reductions and term extensions than on the crucial tool of
principal write-down.
“Our results support the Obama administration’s efforts to seek more
broad-based, systematic loan restructuring,” Quercia says. “They also suggest
the need to reduce the principal amounts on loans, especially loans in which the
household owes more than the home’s worth, to minimize the risk of redefault
long-term.”
