Why Principal Reductions on Loan Mods Aren’t the Move

Unless you live under a rock, you’ve likely heard stirrings of a mega super duper fantastic solve-all trillion-dollar refinance program in the works to save America once and for all.

You know, the one President Obama plans to unveil just in time for the election to give his campaign a shot in the arm (at least that’s what the pundits are saying). For the record, I’m sure any other President seeking a second term would play this the same way.

(Read more about the rumored mass mortgage refinancing plan.)

Well, critics have already come out in droves to have their say about the proposed deal.

One that made me think was an opinion piece by the Motley Fool, who for some reason is talking about mortgages for a change, as opposed to tempting you with their “Hidden Gems.”

Doesn’t Address Underwater Homeowners

Their core issue with the proposal is that it doesn’t address borrowers with underwater mortgages, you know, those that exceed the current value of the associated homes.

The author argues that the lower mortgage payments would certainly help these borrowers (and stimulate the economy), but without any home equity, they won’t have the incentive to refinance.

This is where I think he (and anyone else with this argument) gets it wrong. You see, there are scores of borrowers, dare I say millions, who are underwater and making on-time payments (or at least trying to).

And a program with no loan-to-value ratio constraints that lowers their mortgage rate from 6% to 4% overnight would surely appeal to them, even if they had to pay some closing costs.

I don’t think they would need that extra incentive, in the form of principal reduction, to go through with the refinance.

And I do think a simple interest rate reduction would be enough for many of these borrowers to stay put in their homes, as opposed to buying and bailing, or bailing and renting.

After all, a loan modification should address affordability concerns, not necessarily a homeowner’s desire to stay put. We can’t beg people to stick around for the greater good.

Why Principal Reductions Are Trouble

Clearly borrowers who receive both an interest rate and principal balance reduction will be better off with regard to paying their mortgage, although certain data suggests otherwise.

But it gets to a point where the borrower is getting too much, and the cost is simply too high.

The fact is many homeowners are in negative equity positions either because they purchased homes with no money down, or because they serially refinanced until they zapped all the equity out of their homes.

And some people just bought at the worst possible time. I’ve purchased things at the wrong time too, but never expected to get bailed out for my bad luck.

So taxpayers can’t be on the hook for all these homeowners. It’s also not fair to the homeowners who don’t get any direct benefit. But I’m sure they won’t mind others refinancing to lower rates that they can obtain themselves.

As it stands, an interest rate reduction would be much more cost effective than a principal reduction, and still serve the same purpose.

There are plenty of homeowners who would be very happy to see their mortgage payment reduced by hundreds of dollars a month, even if they’re underwater.

Because let’s face it, if they haven’t walked away yet, there’s a good chance they’re sticking around for the recovery.