Will Mortgage Principal Reductions Work?

Some say principal reductions will save the housing market, but are they missing the downsides?

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Mortgage principal reductions are in the news again as Bank of America announced this week that it will offer them to more than 200,000 borrowers. Should more widespread programs come, principal forgiveness is most likely to be offered to borrowers who are deeply underwater and who have already experienced some level of financial distress, just as Bank of America detailed earlier this week.

But do these offers provide any value? Who decides who is eligible? Will borrowers still be "underwater" if they do get one?

Prepaying with a principal reduction. Consider a principal reduction a prepayment of a chunk of the outstanding mortgage amount.

For adjustable-rate mortgages (ARMs), if the loan balance has been reduced by a prepayment (in this case, a principal reduction), that balance will have a new rate. A borrower's monthly payments will be lowered after a recast, especially if they've prepaid any of the balance.

For fixed-rate mortgages, things are a little different. Prepaying your mortgage—either a little at a time or in a lump sum—does not change the required monthly payment.

Without recasting the loan by restarting the term (a la a refinance), your required monthly payment on a fixed-rate mortgage will be unchanged.

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If a borrower with a fixed-rate mortgage is in trouble, a principal reduction won't help them in the short term. Their monthly obligation remains unchanged. To be effective, principal reductions need to happen in the context of a mortgage modification: A homeowner in trouble receives some combination of lower interest rate, lower loan amount, and restructured term to make loan payments more affordable.

This gift from the loan's investor—which includes taxpayers on Fannie Mae and Freddie Mac-backed loans—strikes many people as unfair. Many taxpayers are also borrowers who are simply underwater but not in trouble. It also irritates homeowners who are not underwater or in trouble, since they would probably like to see their loan's principal reduced, too.

However, it seems unlikely that underwater homeowners who are current on their payments will get principal reductions. Even if they did, the prepayment rules above would apply.

The moral hazard of principal reductions. This leads us to the "moral hazard" issue. Aside from contemplating the actual cost of "retaining homeownership at any cost" (which could run into the tens of billions of dollars), creating a new "reward" for homeowners who have failed to live up to their commitments may lead others to consider abandoning their commitments, too.

A marginal borrower struggling to make payments might see a neighbor in similar straits get tens of thousands of dollars chopped off their loan and a reduced monthly payment and start to think, "Why should I struggle when I could have that...and all I need to do is stop making payments?"

[Read: Fixed Mortgage Rates Fall to All-Time Low on Weak GDP Report, Euro Zone Concerns.]

This perverse incentive could change the behavior of many struggling-but-current homeowners, and this could worsen the situation all around. There is no doubt that being underwater is a problem, but there are many, many underwater homeowners who are paying their mortgages faithfully on time each month, regardless. Simply being underwater is not usually a specific reason for default, but it does raise the incidence of loss if a loan does default.

Will any distinction be made between "victims" of poor timing and hardship versus those who emptied out the equity in their homes during the good times and continued to live beyond their means?

You'll pay for these reductions. If principal reductions promote "sustainable homeownership," as some claim, why aren't they used more frequently?

A lender makes a loan to a borrower. The borrower gets in trouble. The lender agrees to take less interest over a longer term. The borrower gets payment relief, but makes payments based on the full loan amount, so the lender still has a chance to get all its money back, while its "loss" is only one of a diminished return. A principal reduction literally chops an amount off the loan balance, resulting in an instant, unrecoverable loss to the lender.

It's worth noting that you might be one of those lenders, if you have any investment or retirement funds that hold mortgage securities.

Will principal reductions work? If the goal is to keep people who cannot otherwise afford their homes in their homes, the answer would be yes. But is this really a great thing? Should we extend the logic to other items that become unaffordable, such as autos, which also decline in value?

[Read: Fannie Mae Dodges Another Government Bailout.]

If reductions in interest rates to as low as 2 percent, lengthening of repayment terms to as long as 40 years, forbearance, and other common modifications are insufficient, is the borrower really well-suited for the financial realities of homeownership? Even with a reduction, will the homeowner still be underwater, or will that entire underwater amount be wiped out? Will we go as far as to provide an equity stake?

Principal reductions will come with considerable cost to investors and taxpayers, possibly change consumer behavior for the worse, and even reward people who drained the equity from their homes during the boom times.

Bottom line? There are no guarantees that principal reductions will prevent further loss or even promote stable, long-term homeownership.

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  • Keith Gumbinger is a 25-year expert observer of the mortgage and consumer debt markets, and has been cited in thousands of articles covering a wide range of consumer finance and economic topics in outlets ranging from the Wall Street Journal to the Bottom Line newsletters. He has been a featured guest on national broadcasts for CNN, CNBC, ABC, CBS, and NBC television networks and has been heard on NPR and other national and local radio programs. Keith is the primary researcher and writer for HSH.com's MarketTrends newsletter and has authored or co-authored a number of consumer guides on mortgages, home equity, refinancing, and more.