Types of Loan Modification

Interest Rate Reduction:
This is a more effective way to get the payment down. Cutting the interest rate on a 30-year loan from 6 percent to 3 percent will reduce the payment by about 30 percent, whereas extending the term to 40 years reduces it by only 8 percent. Rate reductions are flexible, since they can be adjusted to the needs of each individual borrower. They are more costly to the investor than a term extension, and correspondingly they are more valuable to the borrower.

To minimize the cost, rate reductions in some cases are made temporary. The modification may call for the original rate to be phased back over, say, five years. This presumes that the borrower's payment capacity will grow over the same period.

Capitalization of Arrears:
The past due payments -- and perhaps late fees and other charges arising out of past delinquencies -- are added to the loan balance. A new payment, which will be a little higher than the previous payment, is then calculated.

This is the most common type of modification because it has very little cost to the investor. It’s only value to the borrower is that it provides a new start by making him current. It works for a borrower who has hit a temporary rough patch and is now back on track, but not for a borrower who needs a lower payment.

Extension of the term:
A term extension is the payment reduction modification that is least costly to the investor. However, if a loan was originally for 30 or 40 years and is now only a few years old, the payment can't be reduced very much this way. If the loan was originally for 10 or 15 years, a term extension to 30 years will reduce the payment materially, but 10- and 15-year loans make up a very small share of loans in distress.

Freeze of interest Rate:
On adjustable-rate mortgages that are close to a rate reset date, where the new rate and payment will be well above the one the borrower is now paying, a modification can freeze the rate and payment at the current level. Many subprime loans have been modified in this way because they carried margins of 5 percent to 7 percent, which, when added to the current value of the rate index, would have resulted in substantial increases in rates and payments.

Reduction of Loan Balance (Principal Balance Reduction):
The mortgage payment declines in tandem with the balance. A 20 percent drop in the balance, for example, results in a 20 percent drop in the payment. Unlike a cut in the interest rate, however, a cut in the balance can't be temporary, which makes it the most costly modification for investors and the best modification for borrowers.

Balance reductions do have one major advantage for investors: They reduce the borrower's negative equity, which increases the borrower's incentive to do everything possible to keep the house. It is very plausible that re-default rates on loans that are modified with a balance reduction are materially lower than on other types of modifications.

Step Interest Rate Reduction:
A Step Interest Rate modification works by reducing the interest rate to a low rate that that client can afford for one or two years then the rate will be increased the following year usually by one percent then the following year by around one percent, then the following year by one percent and then may fix itself to that rate on the last year. This is common for clients that may be on a commission based structure and due to the economy, they are not making the money they were, but once the economy turns, then they will go back to making the money they were before.

Forbearance:
Typically 30% of sub-prime lenders (with high interest rates) will only offer a workout program that requires you to immediately pay at least 20% or more of the total delinquencies including foreclosure fees, plus the balance of the delinquency will be added to their regular monthly payments over a period of 6 to 48 months.

Forbearance plans do not remove a foreclosure action but simply stop it in place until the loan is current.

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