Underwater Loan Modifications: Just Kicking the Mortgage/Housing Crisis Can Down The Road?
Question: I have one loan against my home which has a balance substantially greater that the current market value. I am in default on the loan, in danger of foreclosure, and have received an unsolicited long term loan modification, which does not include any principal reduction term. Should I accept it?
Answer: As with everything, the answer depends upon the terms of the long term loan modification. However, a number of general points can be made for your consideration as you determine whether to accept the long term loan modification or not. What is important is that you fully understand what you are being offered, and where you might find yourself some years down the road with such a loan obligation, as modified, in place, and to also realize that lender’s proposal is likely not being made with the best interests of the homeowner in mind.
The following discussion is based on one true life example of a long term loan modification of a loan secured by a first position trust deed against the borrower’s primary residence in Bend, Oregon (the following numbers are all approximations). The balance owed under the loan, including all unpaid interest and other charges, was $297,000. The current market value of the home was $205,000. What terms were offered by the lender for the long term loan modification, and accepted by the
A. The loan term was extended out to 40 years, running from the date of the loan modification.
B. The interest rate was reduced to 4.625% fixed for the entire 40 year term.
C. Approximately $53,000 of the new loan balance was put into what is referred to as a “Deferred Principal Balance”, and it was provided that no payments would have to be made on this amount, and no interest would run on it. However, this Deferred Principal Balance would have to be paid in full if the homeowner sold the property, or the homeowner defaulted under the loan and the debt was accelerated, or upon the new maturity date 40 years from now.
D. The new monthly payment of principal and interest was $1,114. Interest is not run on the Deferred Principal Balance. If interest was run on the true principal balance, the loan would be negative amortizing – meaning the loan balance would actually increase over time. The homeowner also has to make estimated monthly payments of property taxes and insurance into a reserve account.
To give additional perspective to the factors discussed below, here are two numbers for the loan balance in the future:
a. After 7 years, in January, 2020, the unpaid balance would be $278,000.
b. After 15 years, in January, 2028, the unpaid balance would be $250,000.
What has been accomplished with the acceptance of this long term loan modification? The homeowner gets to stay in the home, is able to avoid the time and expense and hassle of having to move and find a new home to live in, but has effectively become a renter (as there is no equity in the property). But unlike a true rental situation, the downside to the homeowner is that the legal liability associated with the loan continues for the long term. And unless the homeowner is going to stay in the property for a substantial period of time, at some point in the future, the homeowner is still going to face the decision of having to go through a short sale or foreclosure, with all of the negative consequences associated with those processes.
What factors should the homeowner consider, or what questions should the homeowner be asking, as the proposed loan term modification is being considered? The following includes my assessment of whether the particular factor is a positive (PRO) or negative (CON) in making the decision about whether to accept a proposed long term loan modification.
1. What are the projections for housing prices? Obviously no one has a crystal ball, but you should be able to get some general idea of the direction that prices are headed, and what the expectations are for the housing market in the area the home is in. If prices are headed in the negative direction, or in a positive direction, but at a tepid pace, say a few percent a year, then it is: CON.
2. Under somewhat of a best case scenario analysis, how long would it take for the market value of the home to reach the level of the debt against it? Or, putting it differently, what percentage increase each year would the home have to appreciate in value in order for the home’s market value to be equal to the debt against the home after, say, seven years? (I use seven years because that is the historical average for a person staying in the same home). If at the end of seven years, the homeowner is still going to have a loan which exceeds the value of the home, then it is: CON.
3. Would the homeowner be better off, financially, to take the credit hit now, rather than waiting until some time down the road? If the homeowner is already in default, the credit hit has already occurred, and perhaps there are other events which have occurred resulting in the homeowner having a low credit score today, and the expectation is that the future will be better and the homeowner will be repairing their credit over the next number of years, then this is a negative consideration for accepting a modification, as the deferral of the major adverse credit consequence of a short sale or foreclosure will now occur at a point in time in the future when otherwise the homeowner has been doing well. Overall: a CON.
4. A refinance in the near future is likely out of the question, given the value of the property being less than the amount of the loan, unless the homeowner brings money to the table to buy down the loan, so the opportunity to take advantage of low interest rates on any refinancing is likely non-existent. CON.
5. What are the current tax ramifications of a short sale of the property or a foreclosure sale versus what might exist in the future? For example, if the home is the primary residence, the exclusion of the
1099 discharge of indebtedness income could be available through the federal Mortgage Forgiveness Debt Relief Act. That legislation may not be around several years from now (it was just extended only for only one year, until December 31, 2013). Likely a CON.
6. What are the tax ramifications of a reduced interest rate? Ordinarily, this would be viewed as a good thing, as out of the monthly payment, the principal balance would be paid down more quickly. But in the context of a substantial underwater property, I believe it could be argued that the homeowner would be worse off, because of the reduced deduction for mortgage interest payments, while the homeowner would be paying more towards paying down principal on a loan which ultimately doesn’t help the homeowner. In fact, one could argue that in any such modification, the homeowner would be better off having an interest only payment for a long term loan. Overall, a CON.
7. What will be the mind set of lenders years from now? Currently, lenders are readily approving short sales at substantial discounts (seriously, in many cases in the hundreds of thousands of dollars), and with a full waiver of the claim for a deficiency, and without requiring contributions by the homeowner. Short sales are also still the best opportunity currently to rid one of the debt of a second position loan, such as a HELOC, and again with a full waiver of the claim for a deficiency. Will the lenders still be willing to do this in the future, once the economy begins to change and the rate of foreclosures or short sales diminish? Probably a CON.
8. If the homeowner cuts their loss now, takes the credit score hit, and immediately begins to improve their credit, would this enable the homeowner to perhaps more quickly purchase a new home at the lower purchase prices and low interests rates which now exist, and probably will for at least the next few years? I believe the homeowner would be better off doing so now, rather than later, so this is a CON.
9. What are the odds that the homeowner will have to move out of the home within a short period of time (say within five years), either because of a change of job, or change of income level, or having outgrown the home because of new family members? A CON.
10. Does the homeowner get to stay in their home, and avoid having to move and find a new place to live? Yes. A PRO.
11. What about the amount of the new monthly mortgage payment, compared to what a rental payment amount might be for the similar properties? Remember the monthly interest and principal payment is only one of many obligations of the homeowner who continues with the loan. There is the additional monthly payment of the real property taxes and insurance reserves. There is also the costs associated with the maintenance and repair of the property, and potential capital improvement costs over time, which would not be the responsibility of the lender, but the homeowner, under the continued home ownership scenario, but would not be the homeowners obligation as a tenant. Factoring all of these costs in, it is possible that the true monthly costs for continuing home ownership exceed the costs of a rental. A slight toss up, but I’ll go with a CON on this one.
Notwithstanding all of the negative considerations, in the short term, it is understandable that the homeowner would accept the proposed loan modification, as the homeowner avoids the immediate dislocation associated with having to move out of the home, and find a suitable replacement home – whether as a purchase or as a rental. But for the long term, I would argue this is a very poor bargain for the homeowner, primarily benefits the lender, and will be a decision the homeowner ultimately regrets. To emphasize, however, the long term loan modifications I am addressing do not include principal reduction components. If a proposal includes a principal reduction component, bringing the new principal loan amount down to current market value, then a completely different analysis would be warranted – but those types of loan modifications are very few and very far between.
Finally, what about the big picture? What does such an arrangement have on the general economy and the still existing housing/mortgage crisis? As noted in the title line, the can is just being kicked down the road. The underwater loan will in all likelihood have to be dealt with at some point in time, and either a short sale or foreclosure will occur. Nothing will have been avoided – the problem’s resolution just postponed for all of us to have to deal with over the years to come.