Reno Foreclosure Blog

I am a Certified General Real Estate Appraiser, but I am also involved in the real estate short sale business. My team of Realtors, Lawyers, Accountants and myself work with homeowners who choose to negotiate a short sale with their lenders so they can sell the “money pit” they call their home and move on with their lives. I often times have home owners ask me how to get out of a mortgage that is almost twice the current value of their home. Some of these folks are in a trial or even permanent loan modification program that offers no principle reduction, which is true in 99% of all loan modifications. (Do you really think banks are going to give away free money by reducing principle?)

Upon the recommendation of my lawyer associate, I am careful as to what advice I give them. I confess that I do not know everything about the various loan modification programs. I suspect very few do, but I will pass on what information I have learned.

It appears to me that in most modifications, deferred interest and fees are tagged on to an extended loan and the principle balance is increased. It also appears that most of the permanent modifications are for approximately 5 years, so my question is this: If the principle has increased or is increasing monthly and home values are expected to keep decreasing for another year or so, in what position will the home owner be in 5 years? They may very likely have a higher principle balance than they currently have and they may still be significantly under water. It is my opinion, that in many cases, a modification that lacks a principle reduction will just prolong the pain.

Here is an example of the message I am trying to convey:  Suppose you purchased a home in 2005-06 during the boom for $450,000 and took out a $400,000 loan. The home now has an estimated value of $225,000 and still falling. In five years, with normal appreciation of 5% a year, it may be worth $290,000. What do you do? Here are some figures to look at. For those of you who do not completely understand how a mortgage payback works, here is a good example:

Original loan balance: $400,000

Original term: 30 years

Original interest: 7%

Original payment: $2,661/month

Total annual payments = $31,932

Total amount of payments in the 1^st five years…..$159,660

Interest paid: $136,186

Reduction in principal after 5 years: $23,474 (5.87%)

Loan balance after 5 years: $376,526

Now that interest rates are at an all time low, maybe the homeowner qualifies and accepts a simple refinance at 4.5% for 30 years. This would result in a reduced monthly payment of $2,026. That’s great! But in Nevada, the majority of homes values are currently 50% to 75% of existing mortgages, so banks will not refinance because there is no equity in the home. The home owner has to either bring more money to the table or default on the loan. Current financing guidelines have also tightened considerably, making the situation even worse. Options are limited.

One option that many homeowners then pursue is either a private or government backed loan modification. These programs also have guidelines that will disqualify many of the homeowners, but if approved, the lender may offer the home owner a monthly payment based on a reduced interest rate as low as 2%.  But what the lenders are really doing is just re-financing the existing 30 yr - 7% rate mortgage to a 40 yr - 5% rate mortgage and “deferring” any reduced payment - adding it on to the principle - to be paid at a later date.

Sample of a Loan Modification:

Original loan balance: $400,000

New loan balance after 5 years of monthly payments: $380,000 (rounded + fees)

New loan term: 40 years amortized at 5%.

The new payment at 5% on a 40 year loan would be $1,832/month.

Maybe the home owner can’t afford this payment either, so the lender offers a reduced payment for 5 years based on a 2% loan but still amortized at 5%. This results in a $1,150/month payment for 5 years, with $681 in deferred interest being tacked back unto the principle.

                         $1,832/month

                        -$1,150/month

Difference:      $681/month

The difference gets tagged back onto the current principle amount so after 5 years/60 months you owe more than you do now. The reader should note that you can’t just simply multiply $681 times 60 months to calculate the increase in principle because a small portion of your payment may be applied to principle reduction (keep in mind – different lenders have different policies), but in the worst case scenario, it could be a $30,000+- increase in principle ( a $380,000 loans with a 40 yr term @ 5% interest results in $93,006 in interest due in the first 5 years of the loan; however 60 months of payments times $1,150/month is only $69,000. This is $24,000 of deferred compounding interest that would be added back on to the principle amount)* – and don’t forget to add any missed payments prior to the modification agreement. Depending on the number of delinquent payments, thousands more could be added to the principle balance. (The average homeowner in foreclosure now is an amazing 461 days behind in his payments). I’ll say it again. Did you really think banks were going to give you free money?

Monthly principle reduction is true for all mortgages, but looking at the first example, it should be noted that after 5 years of mortgage payments, the principle was reduced by 5.87% of the original debt. It should also be noted that in all mortgages, the majority of the monthly payment is applied to interest during the early years of the mortgage. The majority of the payment is applied to principle during the later years of the loan.

Here are the principle/interest figures for the original 7%, 30 year, $400,000 loan.

Monthly payment: $2,661     Annual payments: $31,932 (all figures are rounded)

Year 1:  Principle reduction = $4,063  Interest paid = $27,871

Year 2:  Principle reduction = $4,357  Interest paid = $27,578

Year 3:  Principle reduction = $4,672  Interest paid = $27,263

Year 4:  Principle reduction = $5,010  Interest paid = $26,925

Year 5:  Principle reduction = $5,372  Interest paid = $26,563    

Total principle reduction at the end of 5 years  =  $23,474                      

Year 6:    Principle reduction = $5,760  Interest paid = $26,174

Year 7:    Principle reduction = $6,177  Interest paid = $25,758

Year 8:    Principle reduction = $6,623  Interest paid = $25,311

Year 9:    Principle reduction = $7,102  Interest paid = $24,833

Year 10:  Principle reduction = $7,615  Interest paid = $24,319

Total principle reduction from year 6 to year 10  =  $33,277

The loan principle amount was reduced $23,474 in the first five years but it was reduced $33,277 in the second five year period. During the next 11 to 15 year period the loan principle will be reduced by an additional $47,173. The principle reduction increases at a modified exponential rate, over time. Note, that the amount of interest paid is also being reduced on every payment, but on a 30 year loan, it takes approximately 15 years before the payment is applied 50/50 to interest/principle. 35% of the payment still goes to the bank for interest at year 20. The total interest paid on a $400,000 loan at 7% interest, 30 year term is $558,036.

A 40 year loan results in lower monthly payments but much more interest paid by the homeowner. The total interest paid on a $400,000 loan at 7% interest, 40 year term is $793,148. Remember, more interest is paid at the beginning of the loan and less at the end. On a 40 year loan, more “up front” interest is paid and there is less principle reduction in the early years of the loan. The principle reduction in the first 5 years of the 40 year loan is only $10,910 or 2.73 % of the original debt.

So the question is this: Why wouldn’t lenders want to do a loan modification with a government guarantee? As the government keeps bailing out banks, the banks keep winning (hint and quick note: research the bail out of the Savings and Loans in the 1980’s, after the last oil crisis).

Here is another question: After a 5 year modification period, does the interest rate on the loan get re-adjusted to current rates? Some programs yes. Some programs set the future rate at the time of the modification agreement.  If it does get re-adjusted after five years, there is a very high probability that mortgage rates will be higher. It is also my opinion as a Real Estate Appraiser, Broker, Investor, Building Contractor and Developer with 30 years experience in the real estate industry, that there is a low probability of a significant increase in home values in the next 5 years. A typical appreciation rate of 5% is possible, but I wouldn’t expect any thing better. That means you will have a home worth approximately $290,000 and a mortgage that may be higher than the original amount of $400,000. What have you gained?

One may now ask what choice is better - a loan modification or a short sale. As an appraiser, most questions asked of me are addressed with the same answer: It depends! There are very few situations when a simple answer is appropriate. The business of Real Estate has too many variables. Love of the nest is one of those variables, but so is economics. Stay in the home for 10-15 years and its value will probably recover. You will be close to even. Start over now and in 10-15 years you will most likely have the increased equity normally associated with real estate.

Before the modification versus short sale decision is made, another important question should be addressed. Why is the percentage of loan modification approvals so low? But the more important question is - Why is there such a high re-default rate on those that are approved?

* Some of the numbers stated in this article are hypothetical estimates.