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Jack M. Guttentag The Mortgage Professor

Jack M. Guttentag, The Mortgage Professor

Loan Modification: What You Should Know, Part One

by Jack M. Guttentag

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Posted on Tuesday, October 9, 2007, 12:00AM

A loan modification is a change in the loan contract agreed to by the lender and the borrower. The modifications of major concern today are those designed to reduce the payment burden on borrowers faced with impending rate increases that will make the mortgage payment unaffordable to them. Many are subprime borrowers.

Home owners faced with this prospect, whether they are already delinquent or not, should request a modification. They are very unlikely to get one if they don't ask, and they should make the investment required to make their case. The stakes are very high: They can save their house and their credit.

The Decision Process

In most cases, the decision on a modification is not made by the firm that owns the loan. It is made by a firm servicing the loan under contract to the owner. The owner could be a single lender, or it could be a group of investors who own pieces of a mortgage-backed security collateralized by a pool of loans.

Whoever the owner, the servicing firm is contractually obligated to find the solution to payment problems that will minimize loss to the owner. If the lowest-cost solution is a contract modification, great -- everyone involved prefers a modification to a foreclosure. But if a foreclosure would generate lower costs for the owner, the decision will be to foreclose. The cost of foreclosure to the borrower does not enter the decision.

Yet the decision is far from cut and dried, and it can be materially affected by whether and how the borrower presents his case. On this issue, I have benefited from an exchange with Warren Brasch, an attorney who represents borrowers seeking loan modifications.

The Equity Factor

Perhaps the most important factor affecting the modification decision is the amount of equity the borrower has in his property. If the borrower has enough equity in the property to pay any deferred interest plus foreclosure expenses, foreclosure is usually the lower-cost solution.

Equity depends on property value, which the borrower is much better positioned to know than the servicer. The borrower knows or can easily find out how many houses in the neighborhood are for sale and what the trend has been in recent sale prices. In a weakening market, it is easy for the lender to overestimate value, and the borrower must prevent that.

The Moral Hazard

Servicers fear that, if they are liberal in granting modifications, borrowers who don't need a modification will seek one anyway. They protect themselves against this by entertaining modification proposals on a case-by-case basis, while placing the burden of proof on the borrower.

Borrowers must accept the burden of proof. In addition to the data on property value, they need to document that they cannot afford the payment increase that is pending, and they must document exactly what they can afford.

For this purpose, borrowers should calculate their total debt ratio: the sum of mortgage payment, other debt payments, property taxes, and homeowners insurance as a percent of their gross (before tax) income. This number should be calculated for what it is now, what it will be after the rate adjustment, and what they will be able to afford. On the last, Brasch suggests that a servicer may be willing to accept 45 percent as a reasonable maximum.

The Servicing Cost

Servicers have a self-interest in minimizing modifications, because they add to costs. They try to minimize costs by computerizing the servicing process to the maximum degree possible and standardizing customer-support procedures so that low-paid and easily trained employees can perform them.

Modifications must be handled by a special group that is more highly trained and better paid, and the increased costs from expanding their number cuts into the bottom line. Hence, there is a tendency to be non-responsive in the hope that the borrower will go away.

Borrowers have to be persistent. According to Brasch, "If a servicer says they will call you back...forget about it. You need to call them and call them constantly. They will lose your paper-work, fail to return calls, put you on hold, and then hang up. It's what they do. Keep fighting, calling, faxing. This does work!"

In making their decisions about whether a modification would be less costly than a foreclosure, servicers usually ignore an asset possessed by the borrower that could tilt the balance toward modification. This is the right to future appreciation in the value of the borrower's house. In exchange for a modification that might otherwise be more costly to the owner than a foreclosure, the borrower could pledge a percent of the future appreciation, which could shift the balance to modification. This will be discussed in the second article in this series.

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  • James O - Monday, October 15, 2007, 12:14AM ET  Report Abuse

    • Overall: 3/5

    Good article about how to properly apply for loan modifications. The process should be painful. Too many people applied for ARM's in the heyday of skyrocketing real estate appreciation. I do not buy the "gee I did not know all of the terms in my contract" and the "is it so wrong that I just wanted to live the american dream" or "the salesperson took advantage of me" rhetoric. Just a few facts for all of the "bambi's in the woods": 1. Real Estate is essentially a commodity whose value goes up and down over time. Don't overextend yourself with the expectation real estate value always will go up for you. 2. People who take out ARM loans without doing plenty of research and review in detail every document presented to them before closing (required by law) before signing the contract documentation should not expect the government (taxpayers) to bail them out. 3. If the government intends to allow the "I'm not responsible for my actions or lack thereof" crowd to refinance into a FHA loan at little or no cost than you better damn well offer me the same terms. I'll take a 15 yr. loan at 5.5%...;-). For the record, I worked two jobs to get through college after my dad died and managed to get a good job, work my tail off, pay off my student loans, purchase a condo (5 yr. jumbo) sell the condo (year 4), buy a second home with profit using a 30 yr. fixed mortgage, get an MBA. I made damn sure I had the finances to support my mortgage obligation at every step (28% or less of my gross salary). I volunteer for a non profit that helps people get back on track. I see people everyday with the same mindset. Take responsibility for your actions! If you have an ARM that will reset soon see a financial planner or debt counselor. Do some research at the library if you do not have internet access. For the lady with the sister who can't afford a 3,200 mortgage vs. 2,800 get real. If they can't afford a 15% increase in the mortgage how were they going to pay increased property taxes and cost of living increases over time? If I had ten minutes reviewing there checkbook I'm sure I would find $400 in savings. It just takes some effort and sacrifice on their part to make ends meet. Put a budget together, use an online service such as wesabe.com along with MS Money or Quicken to balance your checkbook and check for ways to save. Put some money each month into a S&P 500 index fund (70%) Lg term Bond Index fund (30%) from Vanguard or Fidelity or another major fund firm. Don't expect the government (ie. american taxpayer) to bail you out.

  • Christopher - Sunday, October 14, 2007, 8:02PM ET  Report Abuse

    • Overall: 5/5

    With the Internet available at our fingertips today, there is absolutely no reason whatsoever why people should have gotten into a toxic mortgage, with the exception of a deceptive broker slipping in additional paperwork. Before I bought a home, I figured out what I would pay monthly, and when the rate would reset after 5 years, I figured out what the interest rates could be, based on historical trends of interest rates. The vast majority of people knew what they were getting into, but either didn't care or didn't calculate what-if scenarios to figure out what the precise impact of a rate reset would be. Aaron, you don't get it buddy. A lot of people will and should lose their homes anyway, because they decided to gamble with buying homes on leverage instead of going to the casino with a little cash. The scenario you are talking about is pretty much the definition of moral hazard. If people cry for bailouts every time they take risks, and they get bailed out, what reason is there to not take additional risks? Also, for those who are giving 1 or 2 stars, many of you are not stating why. Seems like the article is pretty good to me, because it gets to the point of how a loan servicer views modification vs. foreclosure. Most of the articles I have seen only say, "Banks and mortgage companies want to work out loans with you because otherwise they will be left with taking back properties" which is a total crock. This articles puts the subject in the correct context, because most banks don't hold their loans anymore, and the servicer automates everything so anything that gets away from automation is costly to them. And for the person who disputed that the owner knows more about what properties sell for in the area, you would be surprised.

  • Yahoo! Finance User - Sunday, October 14, 2007, 4:43PM ET  Report Abuse

    • Overall: 4/5

    Not everyone has the same reason for buying homes, and not all people have ARMS or other mortgages because they are liars or investors. I have been a professor at a major university for over 7 years and bought my first condo while on sabbatical but because I didn't want to buy the condo in the state where my checks were issued (CT) it was impossible to get banks to understand that I would continue to have a salary despite not "working" for 15 months in order to write a book (the 3 years before that had been work hell so I know from work). I don't understand how people can hate accurate information sharing, when so much of the crisis (no matter which side you are on) is premised on "misinformation." I'm not a fan of avoiding personal responsibility but neither do I think abusive lending practices are a figment of our imagination. This article puts the burden where it should be - on the borrower - to try to work it out without defaulting and without having a fire sale on their own to lower prop values further for their neighbors. And can't we disagree without the name calling? Hopefully we are all adults.

  • james - Sunday, October 14, 2007, 2:19PM ET  Report Abuse

    • Overall: 5/5

    Great article!

  • Jamie - Sunday, October 14, 2007, 12:15PM ET  Report Abuse

    • Overall: 5/5

    Guys, it sounds like most of you are little upset? I don't blame you. My husband and I were both born and raised in our little CA hometown and we have been unable to purchase a house despite trying for the last 4 years. I teach high school and my husband is an electrician. However, my little sister and her husband (architect & wine maker) decided to try and buy a home 3 years ago. My Dad (a mortgage broker for 20 years) put them in their loan with reassurances from the lender that it was a 10 year fixed rate. But this was not the case, there were 3 addendums to the contract and, to make a long story short, my sister's payment went from $2800 to $3200 per month after 3 years. She and her husband are in dire straits! They both work very hard and have two little ones. They are going into credit card debt every month just to put food on the table. When they bought the house, they were debt free and now they owe $50,000! The only money spent was a new roof for their 80 year old house. My point is, please don't be so critical of all the people out there that are struggling in this market. You shouldn't presume to know everybody's situation. My sister isn't a house flipper - she never had that intention. She & her husband simply wanted to pursue the American dream of raising a family in a house "of their own." Is there any harm in that? I don't think so.

  • Yahoo! Finance User - Sunday, October 14, 2007, 10:58AM ET  Report Abuse

    • Overall: 1/5

    I dont understand how ppl can ask for help with their ARM resetting. You basically have two choices when you buy a house, an ARM or a fixed rate. Investors, flippers, and those that couldnt otherwise afford the home often go for the ARM, and those that want a place to raise their family and are not trying to time the market typically go with the fixed rate which is offered to everyone and does not carry risks. ARMs are not cheap gifts from the heavens. Rather, they are designed such that over time the reset rates and prepayment penalties will give the banks a higher return than fixed rate mortgages would. Everyone knows this going in, so why the talk of assistance when the resets actually hit? It's disgusting. Why reward ppl that went for the risky ARM to make fast cash or because they were overextending, and hurt those that were prudent and educated and elected the fixed rate. I strongly encourage everyone to fight bailouts. Any politician that supports this nonsense should be sent packing.

  • Kim - Sunday, October 14, 2007, 10:21AM ET  Report Abuse

    • Overall: 1/5

    Aaron - you seem to not understand the issue. No one is talking about those ppl that bought a house with over a 10% down payment and got a fixed rate mortgage, and has since then has been sick, disabled or unexpectedly lost their job due to no fault of their own. The vast number of foreclosures are due to ignorant "investors" and "flippers" or those that lied about their income, and tried to get into little money down ARMs to make a fast buck after watching an HGTV flip this house marathon. These ppl not only drove up prices beyond the reach of hard working families that would have otherwise purchased these homes to actually live in, but now are asking the government and banks for bailouts. That is why we hate them and think they deserve what they got. Try to stay informed Aaron, and if you chose not to, try not to post. It adds nothing to the discussion.

  • Ripped Off - Sunday, October 14, 2007, 2:12AM ET  Report Abuse

    • Overall: 5/5

    What is the real issue here with all these hate comments? My wife has some uppity repub friends and they spout the same trash as this. But the repub wife is 38 and having her 2nd child after a very problematic 1st pregnancy. The 2nd hasn't been any better, in fact there have been numorous complications and she is now in hospital on total bed rest at week 31. The cost to the insurance provider is without question huge, where is the personal responsibility here. My cost of insurance will be affected by her desision to enter a risky pragnancy and for many other situations like this. Why I should suffer for her benifit is as germain question as you asking why we should 'Bail Out' people stuck in a tight situation. It is unfortunate that you are so blinded that you can not see it will cuase much greater harm to everyone including yourself if millions and millions of families have their homes forclosed on. No one is saying pay off their loans with your tax dollers, no one is suggesting that you be burdened with paying their mortgage. All that is suggested is that the payments that are set to reschedule to an amount far greater than what can be repaid by these folks simply be kept at the present payment amount so that they don't lose their homes. This is not a bail out of real estate agents, loan officers, banks, trusts, CDO owners or managers. It is simply a method of keeping a very troubled economy from tipping past the the point of no return and entering a free fall. What Jack talks about here is a win-win situation where the least amount of damage is done to either side. What you are svreaming for is to see people hurt. My inclination is that most of you are more than likely white, republicans who consider themselves christians. I have spent the last eight years watching how you time and again screw things up from the top down and am no longer interested in anymore of your 'help' with these things you have made enough of a mess as it is.

  • Jim - Sunday, October 14, 2007, 12:19AM ET  Report Abuse

    • Overall: 2/5

    This article only covers one scenario. I had an adjustable rate mortgage and it went up quite a bit, but my mortgage really had very little impact on my financial well-being, so the extra $500 a month just didn't really matter to me (I figured I would either pay it to them or my wife would spend it on shoes), but lo and behold the bank calls me one day and says they want to offer me a loan modification into a fixed rate mortgage at a very low interest rate and it would cost me nothing. I was a bit skeptical at first but looked over the paperwork and sure enough it was just what they said. They even paid for all of the postage on the documents. In the end, I think they just wanted to get the ARMs off their books so their balance sheet looked more solid. I guess it's just a matter of right place, right time.

  • Chen - Saturday, October 13, 2007, 11:33PM ET  Report Abuse

    • Overall: 1/5

    Our system should not reward irresponsible and greedy actions!

  • Yahoo! Finance User - Saturday, October 13, 2007, 4:15PM ET  Report Abuse

    • Overall: 3/5

    Detailed information. Lenders don't want to foreclose unless they have to, so if a modification is in their favor they will accept it. I would say, however, that an ounce of prevention is worth a pound of cure. I suppose frugality and prudence are not considered virtues anymore.

  • Yahoo! Finance User - Saturday, October 13, 2007, 4:05PM ET  Report Abuse

    • Overall: 1/5

    Craig D - I guess you didnt take the time to read Natalie's entire comment. She didnt say the homeowners should be let off the hook. In fact, she said she does not favor a bailout. What she is arguing for is holding ppl responsible. Greedy and ignorant buyers, unethical real estate agents, appraisers and loan officers, wallstreet, the ratings agencies, the fed, and the Bush administration all should be held responsible for this mess. Over the next two years the unwind will be a nightmare. Foreclosures will go through the roof, banks will collapse, there will be billions of dollars in judgements against rating agencies, underwriters and disclosure counsel. Luckily, I was one of the smart ones that could afford a nice home, but realized prices were unrealistic and had to fall. Personally I look forward to it. I lot of sick, unethical and greedy ppl made lots of money screwing people. No bail out, no help, but let the lawsuits fly with respect to those responsible. Actions have consequences. It is you Craig D that needs to understand responsibility. These snakes cannot hide under rocks any longer. Rather than helping this corrupt bunch, to hell with them and what they have done to our economy, and their rape of the middle class. Oh, and dont get me started on HGTV and the ignorant ppl that watch their shows which are nothing more than Lowes and/or Home Depot commercials. Everyone wanted to be the next Donald Trump, but anyone investing in real estate in the last 5 years was Ronald Chump. The only help these tools should get is the phone number of a cheap apartment complex they can move their belongings to that they purchased with all those ignorant refi's. Shame on you ppl. You deserve this.

  • Yahoo! Finance User - Saturday, October 13, 2007, 3:01PM ET  Report Abuse

    • Overall: 3/5

    What every happened to good. old, 100% Personal Responsibility for one's actions?

  • dougd - Saturday, October 13, 2007, 11:37AM ET  Report Abuse

    • Overall: 5/5

    Great info. I am not in danger of being foreclosed, but I am in the last six months of a 5/1 which I was offered as a modification of my loan. In fact, it's the second mod. of loan that Citi offered me. My question is: Why do they offer me such great modifications (this last one was at 4.62) and how can I get another one before June of 2008?

  • CraigB - Saturday, October 13, 2007, 11:14AM ET  Report Abuse

    • Overall: 4/5

    Natalie J, your comment is irresponsible. "...the best thing to do is walk away and consider suing your realtor and appraiser. They are the ones that orchastrated (sic) this scam..." Please spare us your litigious attitude. I agree that home prices lately have been out of reach for most people (using the old reliable: down payment and full doc income approach), but the borrower/buyer needs to be aware of their own doings, assume responsibility and be culpable for the risks taken with any investment. While I am neither a realtor nor an appraiser, I think your allegation that they targeted buyers just to make a buck is typical of someone who thinks “the system” owes them something. Fact is, many people will lose their shirts, but so be it. That’s life. They need to take their lumps, not point fingers, and realize that markets turn a full circle.

  • Yahoo! Finance User - Saturday, October 13, 2007, 7:56AM ET  Report Abuse

    • Overall: 1/5

    There are a lot of things wrong with this article it sounds like it has been written by any of the public who does not have an idea how the modification works. the Home Owner have a better understanding of their homevalue? Don't you think that a Corp. may have Realtors and they will have Appraisers who know the trend and tracking of the most recent transactions. Again I can go on and on but don't have the time but just to say that the article is way off.

  • Natalie - Saturday, October 13, 2007, 4:24AM ET  Report Abuse

    • Overall: 3/5

    Why try to drag it out ppl? Home prices have about 30%-40% more to go down. The best thing to do is walk away and consider suing your realtor and appraiser. They are the ones that orchastrated this scam (yes, i understand Wallstreet's involvement and need and love for asset backed securities, pre-credit crisis that is, but these were not the ones trying to tell scared buyers if you dont buy now you may be left behind forever and making them destroy their families savings in the name of a fast commission). If they were honest, they would have told you home prices only go up about 4 or 5% a year and anything more than that is an unsustainable bubble, that the due to leverage buying in a seller's market with little equity is riskier than playing the stock market (i.e., unless you are buying on margin, your investment in stocks at most can fall to zero, but buying a house with little or no money down can result in you having to come out of pocket large amounts of money or face foreclosure and/or bankruptcy), and that if you cant afford at least 10% down and a fixed rate mortgage you really can't afford the house. If you have little equity don't even attempt to keep your home. This downturn has just started. Next year will be much, much worse. Fighting for your overpriced home while prices are falling rapidly, and will continue to fall rapidly, is a lose lose scenario. I also hope that the government doesnt try to bail out the ignorant and greedy ppl that bought in the last few years with the hope of selling for a profit. Once all the dust settles, maybe a middle class person can afford a middle class home again. Unfortunately, realtors and appraisers targeted buyers in the last three years as nothing more than worthless marks. Those that are educated stayed clear. Those that fell for unethical tactics may walk away broke, but at least they learned a valuable lesson.

  • Yahoo! Finance User - Saturday, October 13, 2007, 2:27AM ET  Report Abuse

    • Overall: 2/5

    It's time for Robert Kiyasake's article again! He often brings good points in simple language. But he needs to target towards audience outside financial field as well.

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