Turning 'Upside Down Mortgages' Right Side Up

(Jan. 14) -- You've got an "upside down mortgage," owing more than your home is worth.

With a 6 percent interest rate on your $400,000 mortgage, the $2,400 monthly payment is brutal. You can barely make ends meet.

The bank agrees to defer $75,000 of the debt, which you'll pay back when you sell your home. The lender also slashes your interest rate to 3.75 percent.

The new $1,500 monthly payment on the $325,000 balance puts a $1,000 wad in your pocket every month. You see your mortgage begin to surface, and the headaches disappear.

That's the kind of scenario Federal Deposit Insurance Corp. Chairwoman Sheila Bair would like to see played out more often for struggling homeowners, especially when a loan modification without a principal reduction could force them to simply walk away from their homes.

A mortgage modification occurs when the lender reworks the terms of your existing home loan, typically to lower payments and make the home more affordable. To build in more affordability, lenders lower the interest rate and extend the loan term, but rarely reduce the principal to get the payment down.

While it might stain your credit, a modification is a better alternative to losing your home to foreclosure or a short sale. And if your mortgage is upside down, a more expensive refinancing is probably out of your reach.

Unfortunately, most mortgage modifications are short-lived, lasting only up to five years, at which time the lender can revert to the original loan or resume foreclosure proceedings. Chances are, after five years, on a mortgage deep underwater, the borrower will return to the same submerged predicament.

"You will be back at square one when the loan modification expires. Do lenders really think that these homes will double in value in two to five years and you will be able to refinance?" asks Robert Aldana. A San Jose, Calif., real estate agent, he created Home Resolution & Credit Services Inc. to help homeowners through modifications.

"It makes me wonder what they are up to and why they are prolonging the inevitable," Aldana says. "Are they just collecting rent for the next two to five years while they try and make their portfolios look good?"

On the other hand, the argument goes, if the lender includes a mortgage-principal reduction in the modification, bringing the balance more in line with the home's depressed value, the borrower gets a better shot at retaining homeownership.

"Agreeing to reduce a homeowner's principal balance to reflect their home's current fair market value would provide homeowners with the benefit of remaining as homeowners and also allow them to obtain a more affordable mortgage payment as a result. The housing market would soon stabilize," says Michael D. Rodriguez, broker/owner of Platinum Capital Mortgage and Real Estate in Salinas, Calif.

After cajoling lenders with voluntary modification guidelines, offering lenders monetary incentives to write more modifications, and banning them outright from ending some modifications, federal Making Home Affordable efforts to get lenders to reduce the principal -- short of a court-ordered mandate to do so -- may be the last shot at making more manageable modifications possible.

"We're looking now at whether we should provide some further loss sharing for principal write-downs," Bair told Bloomberg News.

Bair wants more cash incentives to induce lenders to cut the principal on as much as $45 billion in mortgages acquired from FDIC-seized banks.

Principal reductions do work. They create modifications that are twice as effective in slowing reoccurring defaults than those that only reduce the interest rate, according to a New York Federal Reserve Bank study, "The Home Ownership Gap," published in December.

However, consumer mortgage expert Peter Miller, of Silver Spring, Md., says three factors loom in opposition to some principal reductions:

• Reduced principal immediately shows up on lenders' books as losses. Investors recoil at losses.

• So-called "Option-ARMs" (adjustable-rate mortgages) generate a higher principal through negative amortization -- unpaid interest. The toxic Option-ARMs allow borrowers to pay less than the interest each month. Reducing the principal on these loans means reporting big losses, as well as restating alleged earnings from prior years, says Miller, publisher of the Ourbroker.com mortgage information portal.

• Continued unemployment levels indicate that for some borrowers no loan is affordable. They just don't have the income.

"I look for foreclosure levels in 2010 that pretty much mimic what we saw in 2009," Miller says.