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 Roberto Quercia, director of the center, part of UNC's College of Arts and Sciences. "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 modification 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."
The complete study report can be found at http://www.ccc.unc.edu/documents/LM_March3_%202009_final.pdf.
Home mortgage finance is a key area of research and analysis for the UNC Center for Community Capital, the leading center for research and policy analysis on the transformative power of capital on households and communities in the United States. The center offers in-depth analyses that help policymakers, advocates and the private sector find sustainable ways to expand economic opportunity to more people, more effectively. For more information, visit www.ccc.unc.edu.