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."