Principal Reduction Loan Modification


As I’ve been advising people for several years, you are probably going to be able to get the best loan modification terms if your loan was previously owned by a now-failed bank.  That is because of the FDIC involvement. The exact reasons are complicated, and too long for this blog. Call or write if you are interested.

I’m going to give you some details below regarding loan modifications involving failed banks.  Failed banks that were once active in Alabama include Amtrust, Capital South, Colonial Bank, First Lowndes Bank, New South Federal,  Nexity Bank, People’s First Community Bank (based in Florida), and Superior Bank.  For a complete list of failed banks, click HERE.

When the FDIC takes over a failed bank, it usually sells most of the loans and some bank buildings and personal property to an “assuming bank.”  It’s called an assuming bank because it also assumes—takes over—the deposit liabilities.  If the insured deposits total $500 million, the FDIC might give the assuming bank a check for $515 million to cover all the deposits plus a little extra for “fooling with things.”  By the way, this is a sweet deal for the assuming bank, because it gets a massive amount of cash, but doesn’t have to pay depositors right away. In fact, most depositors will leave their money in the bank for years!

Anyway, back to the loan modification. As part of the agreements, the FDIC and the assuming bank enter into a Purchase and Assumption Agreement.  Part of that agreement details how to handle borrower requests for loan modifications. The FDIC has its own loan modification program, in addition to the typical HAMP programs and others.

This is what is exciting about the FDIC loan modification program:  You can reduce the principal balance of your loan!

You apply for an FDIC loan modification if the bank that owned your loan has been closed by the FDIC and a new bank has taken over. You tell the new bank that you want an FDIC loan modification.  Once you request it, the following steps are taken by the bank to analyze if you qualify. Whichever STEP you qualify for, you’ll still need the meet the requirements of STEP SEVEN, so be sure to read all the way to the end.

STEP ONE:

If the loan is in default, start by adding up the principal balance due on the loan, plus all past due interest, unpaid escrows, and 3rd party fees (such as pre-foreclosure appraisal, attorneys fees, etc.)

That number will be the new principal balance of a possibly modified loan.  We’re going to call that the Capitalized Principal Balance, meaning that past due interest and expenses have been added to the principal, or “capitalized.”

STEP TWO

Use an interest rate equal to the then-current Freddie Mac Survey Rate for 30-year fixed rate mortgage loans.  This is currently 4.51%  To check the rate during any week, click HERE.

See what the monthly payments would be with the new principal amount and the new interest rate, if the loan were paid over the course of 30 years.  We’re going to call this “Estimated P&I Payment”

STEP THREE

Calculate borrower’s gross monthly income (without any payroll deductions for taxes, insurance, loans by employer, etc.)

Add together the Estimated P&I Payment, plus 1/12th of the annual taxes and 1/12th of the annual insurance expense.  We’ll call that new number “Estimated Monthly Payment”

Divide Estimated Monthly Payment  by gross monthly income.  If the number is 0.31 or less, then this is the version of loan modification you can expect. In other words, if your housing payment is 31% or less of your gross income, you qualify at this stage of the analysis.  You will have a new 30-year mortgage loan at a low interest rate, no matter what your credit score is!

If the number is larger than 0.31, then go to STEP FOUR.

STEP FOUR

The bank will reduce the interest rate until the resulting ratio is 31% or less. The bank can reduce the rate all the way down to 3% per annum, fixed, but it can’t go any lower.  If the ratio gets down to 31% at this stage, then this is the modification you will get.

If the number is still larger than 31%, then go to Step FIVE.

STEP FIVE

Increase the mortgage term to 40 years instead of 30 years, and keep the interest rate at 3%.  NOW see if the monthly payments divided by the gross monthly income will be 0.31 or less. If they are, then this is the modification you will receive.  If the number is STILL larger than 0.31, then go to Step SIX.

STEP SIX

The bank will start with the “answer.” In other words, what monthly payment is necessary in order to be 31% of your gross monthly income? We’re going to call that number the Necessary Monthly Payment.  Remember, if you do not pay tax and insurance escrows, then you use 1/12th of the annual taxes and insurance as if they were part of your Necessary Monthly Payment.

Next, start reducing the principal balance of the loan until the monthly payment on a 40 year mortgage at 3% interest equals the Necessary Monthly Payment. Remember, the principal balance we start with is the Capitalized Principal Balance we calculated in STEP ONE. That’s the principal balance at time of default, plus all the past due interest and other charges have been added, but no penalties or late fees. Penalties and late fees are  just forgiven.

When you get the principal balance reduced low enough so the monthly payments equal the Necessary Monthly Payment, look to see how that reduced principal balance compares to the Capitalized Principal Balance.  If the Reduced Principal Balance is 75% or more of the Capitalized Principal Balance, then you will qualify for this type of loan modification.  If it is less (meaning the Reduced Principal Balance is less than 75% of the Capitalized Principal Balance) the the bank can decide if it wants to restructure the loan or not.  If you meet the 75% or more test, they MUST restructure the loan, assuming you meet the final requirement in STEP SEVEN.

If you qualify, this is how the modification works:

A.  The loan will be split into two parts.

B.  One part will be the Reduced Principal Balance necessary to get your payments down to 31% of your gross monthly income.  You will be responsible for making those monthly payments over the course of 40 years.  Even if your income goes up, you will still have the same modified loan and the same payments.

C.  Calculate what I call the Leftover Principal Balance. If your Capitalized Principal Balance was $100,000, and $75,000 of that is set up on monthly payments, then the “left-over” portion will be $25,000.

D.  The Leftover Principal Balance is still owed. It does not accrue any interest. You will not owe any interest on it!  You will owe the money (the $25,000 in my example) when the loan matures (in 40 years) or when you sell the property or when you refinance, whichever happens first.  This provides an excellent opportunity to keep your home and ride out the economic downturn until real estate values come back up again.

STEP SEVEN

There’s one final step to all of this, but it almost always works out in favor of the borrower. After the bank figures out what loan modification you qualify for, it must then compare that to a foreclosure scenario. If the bank makes out better in a foreclosure, then you will not be given your loan modification. If the bank makes out better with a loan modification, then you will be approved. Those calculations are too complicated for this blog, but involve adding up income, subtracting expenses, and then reducing everything to present value.

You can assist with that calculation if you, or your real estate agent, can give the bank information about comparable recent sales and comparable foreclosures.  I recommend coming up with 10 or 20 comparables. The typical appraisal ordered by the bank will have only 3 comparables.  If that appraisal is unreasonably high for some reason, I want the bank to already have my analysis in their hands. That way, if I have 20 comparables and say I think the property is worth $59,000, but the appraiser has 3 comparables and says the property is worth $120,000, guess who is going to look like they are wrong?  Right, the appraiser! The bank will order a new appraisal. I don’t have to “fight” the appraiser, because I got my information in FIRST, and I had a lot more data.

The goal is to get the value as low as possible and still be realistic and honest. The lower the comparables number, the worse off the bank will be with a foreclosure. That’s the goal–for the bank’s analysis to show they will ultimately get less money than with a modification.

This is a lot of information, but it’s just simple arithmetic.  If you are interested, I’ll develop a spreadsheet so you can just plug in your own numbers and see how things work out.  Just let me know.

Real estate agents:  I know you don’t make commission income if a homeowner modifies their loan rather than short sells.  BUT, speak to your brokers and see if you might be able to earn some fee income by providing borrowers with comparables information for their market place.  You’re just giving details regarding comparables, you will NOT be calculating a value for the property. Remember, also, to check deed records for foreclosures and foreclosure bid prices. That information won’t be on MLS, but it is vitally important to the comparables.

I hope this helps!