loan modification

The Two-part Test of Loan Modification


Loan modification is a complicated and convoluted procedure that not many borrowers are aware of. This is why their loan modification applications tend to get rejected even before the process begins. Many borrowers fail to understand the complicated financial analysis that is involved in the loan modification process.

Every loan modification has to pass through a two-part test in order to qualify for government incentives and be approved by the lender.

The Front-End DTI

The first part of loan modification is to qualify for HAMP or the Home Affordable Modification Program. You can qualify for HAMP if your current monthly mortgage payment exceeds 31% of your gross monthly income. This is when your current monthly payment would be termed as unaffordable. It is called Front-End, Debt-to-Income Ratio.

The Front-End DTI is not such a big hurdle since most borrowers who are in financial trouble end up paying more than the 31% threshold. Nevertheless, most borrowers make the mistake of showing the lender that they have absolutely no income. This is when their loan modifications get rejected. Loan modification is about lowering the Front-End DTI to 31% or below. But if the borrower has no income nothing can be done to make the payment affordable. There is a limit up to which the principal or interest rate can be reduced or the term can be extended to make the loan payments affordable.

There are borrowers whose housing debt payments do not exceed 31% of their gross income. However, they have so many other bills that make their mortgage payments unaffordable. Such borrowers fail the Front-end DTI test since the lenders do not consider the overextension part.

The Net Present Value

The second part of loan modification is the net present value that helps a lender determine the extent of loss he might suffer by providing a loan modification. He will have to choose between modification and foreclosure, basing his choice on the option that gives him the highest NPV.

Both modification and foreclosure help the lender recoup some money that he had lent to the borrower. If he chooses loan modification he will receive the money (principal + interest) in monthly payments over a period of 30 to 40 years (albeit, at a lower interest rate). He will have to consider the worth of the stream of 360 or 480 monthly payments in today’s dollars.

However, if the lender chooses a foreclosure over modification, he will sell the property at an auction and get a lump sum amount (after paying the sales and the foreclosure costs) which he can lend to a new borrower at the interest rate currently running in the market.

The lender will have to make a comparison of the net present values of both situations and then make his decision on whether or not to approve the loan modification. If he approves, he will have to make efforts to comply with the Front-End DTI test by reducing the interest rate, extending the term, or reducing the principal amount. Considering all this, a foreclosure generally seems to be a better option to most lenders, which is why they reject loan modifications.

It is the NPV test that mostly kills the loan modifications and unfortunately, in most cases the borrowers are not even told why they don’t qualify for loan modification. This is why there are loan modification counselors who can increase the chances of approval. They understand what it takes to clear these tests and advice accordingly. In fact, most of these professionals get in touch with borrowers through loan modification leads. It can be worth considering their help rather than letting the disappointment of rejection take a toll on you.

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