Have you ever wondered how the servicer decides what terms to offer when evaluating a borrower for HAMP? Despite appearances, the terms that are modified are not arrived at randomly. The servicer applies a “waterfall” that specifies which terms will be adjusted, to what extent, and in what order.
The waterfalls—there are a few—are described in the MHA Handbook for Non-GSE Loans and in Fannie Mae’s and Freddie Mac’s Servicing Guides. These documents are all publicly available and regularly updated.
Standard Waterfall for HAMP Tier 1
For a HAMP Tier 1 modification (think “HAMP Classic”), the standard waterfall works like this:
STEP ONE: First, the servicer capitalizes the arrears. What does this mean? The servicer adds up the missed principal and interest payments, costs already incurred, and any amounts the servicer advanced (or expects to advance during the trial period) for property taxes and insurance. The total arrearage is added to the unpaid principal balance (UPB).
For example, suppose Beatrice owes $100,000 on her loan and has missed $20,000 in payments, but there are no expenses or escrow advances. After capitalizing the arrears, her new UPB is $120,000. Notice that Beatrice will now be paying interest on her missed interest payments.
STEP TWO: Next, the servicer begins reducing the interest rate in small increments of 0.125%. The goal is to get the borrower’s monthly housing cost (principal, interest, taxes and insurance) down to 31% of gross income. The floor interest rate for HAMP is 2%. If reducing the interest rate to 2% does not result in a 31% ratio, the servicer moves on to the next step. (Note: The full interest rate reduction typically is for five years and thereafter increases in steps until it hits the “interest rate cap,” which is based on the Primary Mortgage Market Survey (PMMS). The current rate is available here.)
For example, suppose Beatrice has an adjustable rate mortgage (ARM) with a 6.75% interest rate. The servicer will convert the loan to a fixed rate and begin reducing the rate in 0.125% increments until the monthly housing ratio hits 31% or the servicer hits the floor of 2%. In most cases, Beatrice will end up with a 2% fixed rate mortgage for the first five years, with two or more steps up in the rate in succeeding years up to the interest rate cap.
STEP THREE: Unless the investor prohibits term extensions, the servicer must begin extending the term of the loan, i.e., how many months the borrower will pay on the loan. The maximum term is 480 months or 40 years.
For example, if Beatrice has a 30-year loan, the servicer can extend the term out to 40 years to try to hit the 31% target ratio. Notice that Beatrice will now be paying interest over a longer period of time and will ultimately pay quite a bit more for her home than she originally bargained for, even though her rate is lower.
STEP FOUR: If the monthly housing ratio still exceeds 31%, the servicer has another tool: principal forbearance. The servicer will defer a portion of the principal to the end of the loan resulting in a balloon payment. The borrower will not pay any interest on the deferred principal, but the principal is not forgiven. The servicer can defer up to 30% of the UPB but need only defer down to 115% LTV. (For more about the difference between forbearance and forgiveness, see Did You Know? The Difference Between Principal Forbearance and Principal Forgiveness.)
For example, suppose that Beatrice’s home is worth $90,000. The servicer can forbear $16,500 of principal (115% x 90,000). Beatrice will not pay any interest on the $16,500, which she will owe as a lump sum when her last payment comes due.
At the end of this four-step process, Beatrice’s loan terms have changed quite a bit. She started with a fully amortizing, 30-year mortgage with an adjustable 6.75% interest rate and a UPB of $100,000. Now Beatrice has a 40-year fixed rate mortgage with a 2% fixed interest rate (that may rise a couple of percentage points after the first five years), a UPB of $120,000, and a $16,5000 balloon owing at the end of her loan.
Beatrice’s modified loan isn’t great, but it isn’t terrible. She now owes $30,000 more than her home is worth. Her monthly payments have been reduced by at least 10% (a HAMP requirement) and are now at or less than 31% of her gross income. She will be current again and no longer facing foreclosure. If Beatrice had a larger arrearage or was deeply underwater, the modified loan could look much, much worse.
(Note: For purposes of this article, we are ignoring Beatrice’s total debt ratio and the net present value of the modification. Both factors could disqualify Beatrice for a HAMP modification even if the waterfall produces a housing ratio of 31% or less.)
Alternative Waterfall for HAMP Tier 1
Because Beatrice’s loan-to-value ratio is greater than 115%, the servicer also must run the alternative waterfall for HAMP Tier 1. In the alternative waterfall, there is one more step between capitalizing arrears and reducing the interest rate: reducing principal. This extra step does not apply if the investor does not allow principal forgiveness. For example, if the loan is owned or guaranteed by Fannie or Freddie, forgiveness is not an option.
The new step requires the servicer to reduce the UPB until the borrower owes 115% of the property’s value or, if less, until the 31% housing ratio is met. (Some investors require the servicer to use a different LTV ratio.)
For example, suppose the investor that owns Beatrice’s loan allows principal forgiveness. After capitalizing the $20,000 in arrears, the servicer can reduce her principal by $16,500 to bring her LTV to 115%. If that reduction is not enough to reduce her payments to 31% of gross income, the servicer will move on to the third and fourth steps above.
Beatrice may be required to earn forgiveness from her investor. If so, Beatrice will have to make timely monthly payments for several years. At the end of each year, a pro rata portion of the forgiveness amount will be deducted from her UPB. In the meantime, the amount of principal to be forgiven will be treated as deferred, non-interest bearing principal. If Beatrice misses too many payments, the unapplied forgiveness will be lost and Beatrice will have to pay it back.
For example, the servicer may require Beatrice to earn the $16,500 principal reduction by making timely payments for five years. At the end of each those five years, her principal balance will be reduced by $3,300 (one-fifth of the $16,500). If Beatrice defaults in the middle of year two, she will not lose the first year’s forgiveness, but there will be no reduction in years two through five.
Standard and Alternative Waterfalls for HAMP Tier 2
Borrowers who do not qualify for HAMP Tier 1 may be considered for HAMP Tier 2. The waterfall works the same as it does in HAMP Tier 1 but the terms are less favorable. Tier 2 also has an alternative waterfall for investors who allow principal forgiveness.
In the standard waterfall, as before, the servicer capitalizes the arrears first. A new fixed interest rate is set that is a little higher than the PMMS rate mentioned above. (That rate is generally well above the 2% floor that Tier 1 offers.) The term of the loan is extended to 40 years. Finally, principal forbearance is calculated down to 115% LTV but no more than 30% of UPB. The resulting monthly principal and interest payment must be at least 10% less than the current payment, and the total debt ratio must be between 25 and 42%. Just like HAMP Tier 1, the alternative waterfall inserts a principal forgiveness step between capitalizing arrears and reducing the interest rate.
For example, suppose Beatrice’s property is a rental. Beatrice does not qualify for a modification under Tier 1, so she is evaluated for a Tier 2 modification. After capitalizing the $20,000 arrearage, the servicer will reduce Beatrice’s interest rate to the current fixed rate, which could result in an interest rate several points higher than what Tier 1 would offer. Beatrice’s 30-year loan will be reamortized over 40 years and a portion of her principal will be deferred until the end of her loan, leaving her with a balloon payment. If these changes do not result in a 10% reduction of her principal and interest payments, she will be denied. If her total debt ratio still exceeds 42% of her gross income, she will be denied. In either case, she still may be considered for programs other than HAMP.
Transparency and HAMP Waterfalls
Understanding the waterfalls creates some transparency in the loan modification process. A borrower or her attorney can approximate the modification terms using the current UPB, the amount of the estimated arrearage, and the published PMMS rates. Even if the servicer refuses to disclose material terms of the modification at the TPP stage, which is common, it is possible to compare your estimate with the servicer’s offer.
If the servicer offers a trial period plan or permanent modification with substantially different terms, there are a few possibilities. The servicer screwed up—often the problem. The investor may limit or prohibit forgiveness, term extensions, or forbearance, resulting in only a partial application of the waterfall. Or, in many cases, the borrower does not qualify for a HAMP modification and the servicer is using standard non-HAMP terms, which are typically less favorable.
If the terms of a HAMP modification vary greatly from your estimate, it may be worthwhile to determine which of these possibilities is at fault. If servicer error is the problem, you may need to escalate or appeal the determination.
Putting HAMP in Perspective
Keep in mind that HAMP modifications represent a minority of all loan modifications. For non-HAMP modifications, a similar waterfall might apply but the investor may use higher interest rates, higher payment targets, and favor term extensions over forbearance and forgiveness.
For example, standard non-HAMP modifications for Fannie loans use a fixed rate set by Fannie, which is higher than HAMP’s 2% floor. While other terms are similar to those in the standard HAMP waterfall, the goal is to reduce principal and interest payments by 10% (as opposed to HAMP’s 31% housing ratio target). These differences may result in a much less affordable modification than a borrower could get under HAMP.
As always the devil is in the details. HAMP allows servicers to diverge from the standard waterfalls as required by the investor. Some borrowers may be offered more favorable terms, and others may be offered less favorable terms, even though both borrowers are technically receiving HAMP modifications. And in most cases the borrower will never know, or at least will never know why.
If you are an Oregon borrower in default or struggling to stay current, visit your local HUD-certified counseling agency for more information about loan modifications and free help in applying for HAMP. A searchable list of counseling agencies is available at www.homeownersupport.gov.