The goal in modifying mortgage loans is to bring the borrower current while reducing the total monthly housing cost (principal, interest, taxes, insurance and HOA dues) to a target percentage of gross monthly income (usually 31%). The servicer achieves this payment reduction by serially modifying specific loan terms, especially the interest rate and the length of the repayment period.
If lowering the interest rate and extending the loan term are insufficient to hit the target, the servicer may include principal forbearance. For some lucky borrowers, a lender may even forgive principal. But what’s the difference between forbearance (which is common) and forgiveness (which is relatively uncommon)?
What Is Principal Forgiveness?
Principal forgiveness (aka principal reduction) occurs when the lender permanently reduces the unpaid principal balance. In other words, the lender writes off all or part of the loan. Principal forgiveness often must be earned by making timely payments each month for several years. A pro rata portion of the forgiveness is earned each month and applied annually. Miss a few payments, and the borrower may lose out on the remaining forgiveness. You might think of pro-rata principal forgiveness as a reward for keeping a modified loan current.
For example, the Making Home Affordable program includes a principal forgiveness option called HAMP-PRA (for Principal Reduction Alternative). Assuming investor guidelines permit principal forgiveness, a participating servicer must reduce principal to the greater of the target DTI ratio (31%) or 115% LTV. The principal forgiveness must be earned over three years, with one-third of the forgiveness applied at the end of each year.
To err is human, to forgive, divine. – Alexander Pope
Some investors, most notably Fannie Mae and Freddie Mac, do not allow principal forgiveness. If a loan is owned or guaranteed by Fannie or Freddie, principal forgiveness is off the table for now.
What Is Principal Forbearance?
Principal forbearance is not nearly as favorable as principal forgiveness. When principal is forgiven, the borrower never has to pay it back. With principal forbearance, the borrower still pays all of the principal back, but the lender defers payment of a portion of the principal until the end of the loan. Forgiveness means an underwater borrower may be closer to equity. Forbearance means an underwater borrower is no closer to equity than he started and, all things considered, may be more upside down.
Forbearance works like this. Let’s say you owe $100,000 on a mortgage loan with 25 years remaining. The lender agrees to forbear on $10,000 of principal. The lender will reamortize $90,000 over the remaining 25 years and you will have a balloon payment on the remaining $10,000 due at the end of the loan. By deferring some of the principal until later, the borrower’s monthly payments are reduced.
Under HAMP, for example, the last step in the modification “waterfall” is principal forbearance. If the servicer reduces the interest rate to the 2% floor and extends the loan term out to the maximum 40 years and the monthly payments still exceed 31% DTI, then the servicer may forbear no more than 30% of the unpaid principal balance to hit the 31% target.
There is a limit at which forbearance ceases to be a virtue. – Edmund Burke
Keep in mind, however, that the first step of every loan modification is capitalization of the arrears. So the unpaid principal balance first goes up and then a portion of that increased principal balance is deferred.
To recap, the critical difference between forgiveness and forbearance is that with forgiveness, the borrower will not pay back the forgiven amount. With forbearance, the borrower will pay it back, but not until later. Forgiveness is good. Forbearance is, at most, bearable.If you are a homeowner struggling to stay current or already in default, please contact a HUD-certified counseling agency near you for free help analyzing your options and negotiating an affordable loan modification with your lender. A searchable list of Oregon housing counseling agencies is available on www.oregonhomeownersupport.gov.