New Wrinkles in Loan Modification Deals - TheStreet

Consumer mortgage loan advocates have long said that the best way to help struggling homeowners is not to cut interest rates, but to cut the principal on mortgages. Now it looks like they finally be getting some traction, as more banks agree to do the once unthinkable.

For the record, mortgage lenders aren’t required by law to cut mortgage principals as part of loan modification deals. Principal reductions are only one item on the government loan modification menu, along with extending the term of the loan and lowering the loan interest rate.

But data is beginning to emerge that suggests banks make out better in the long run if they take a paring knife, but not a meat cleaver, to loan principal amounts.

One big reason is a psychological one. Homeowners who are underwater on their mortgage don’t have the incentive to make good on their loan obligation if the value of their loan exceeds their home's value. By driving the principal amount south of the home’s current value (and this certainly wouldn’t apply in every underwater scenario) banks stand a better chance of getting a solid financial effort from the homeowner.

The numbers bear this notion out. According to the Lender Processing Services June 2009 Mortgage Monitor Report, homeowners who get the principal reduction deal do better than homeowners who get the interest rate version of a loan modification.

According to the report, "the success rate for loss mitigation-related loan modification hovers in the 30-40% range, with a higher success rate for loan modifications involving a reduction in unpaid principal balance."

Banks tend to make more money when borrowers stay in their homes longer. That’s why, according to the Office of the Comptroller of the Currency, loan modifications that included principal reductions rose from 3.1% in the first quarter of 2009 to 10% in the second quarter of 2009. And in the third quarter of 2009, the percentage of loan modifications involving principal reductions rose to 13%.

The OCC also reports that loan modifications that include interest rate reductions are, in a word, failing. The agency says that, of the loans modified in the first quarter of 2009 using interest rate reductions, 28% were in default within 90 days. And one year later, 56% were once more in default.

Before you reach out to your bank for a loan modification deal that makes cutting your loan principal a priority, know one key thing. By and large, the banks that have loan principal reductions on the table invariably own the mortgage on the home. The ones that don’t own the homes aren’t offering such loan reductions.

To see if you qualify, ask your bank if it owns your mortgage – or if it has sold your mortgage to a pool of investors. The difference could mean big savings in any loan modification deal.