Principal forgiveness, once a 10-foot-pole kind of topic, is not only discussed more by lenders, it’s also increasingly being perceived as good business for folks with a stake in home loans. In its ideal use, this type of loan workout keeps underwater borrowers like Marvel in their homes, while investors and banks continue getting paid.
Opponents say these selective deals may lead to moral hazard, a buzz term that means borrowers take risky moves in hopes that they’ll get bailed out.
Either way, several signs point to the increased use of mortgage write-offs. The U.S. government reported last week that loan servicers included principal reductions in more than 10 percent of loan modifications during the first three months of the year. That’s up from 3 percent in the same time period last year.
The write-downs are expected to climb, in light of this year’s 49-state settlement with the major banks. As part of the deal, lenders must reduce the principal balances or perform short sales for about 250,000 underwater Californians, to the tune of $12 billion.
Bank of America, for one, has begun sending about 10,000 letters a week for the past six weeks in its attempt to get borrowers to apply for its in-house mortgage-forgiveness program. Many lenders are expected to send out their solicitations during the third quarter.
How do principal reductions work?
A principal reduction occurs when a lender cuts the amount that a borrower owes on a home to something more affordable. What’s reduced is essentially forgiven by the lender.
For example, borrower John Doe owes $100,000 to Bank ABC. Doe, who is going through a financial hardship, cannot pay his current monthly mortgage amount and is approved for a principal reduction by his lender.
The lender determines that reducing the loan balance by $20,000 would make Doe’s payments more affordable, so $20,000 of the total mortgage amount is written off, or forgiven. The new loan is for $80,000, and the monthly payments are adjusted accordingly.
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