Are Loan Modifications Good or Bad?

A new report from bank regulators shows that Banks are beginning to lower the principal amount due on home mortgages for some struggling borrowers, a practice known as a Loan Modification. Banks are betting that by taking the hit now they can improve their chances of being repaid. Over the next few years banks and other lenders will be wading through thousands of loan mortgage modification applications. The approval rate of loan modifications in the second quarter of 2009 was 10%, which is a 7% jump from the first quarter, based on a Office of the Comptroller of the Currency Report.

Banks now have the capital to justify loan modifications because of their balance sheets have stabilized with an influx of government cash. The Obama administration announced plans to help underwater homeowners in March. The plans include financial incentives for mortgage-servicing firms that modify loans. However, the plan involved handing over billions of dollars to troubled banks with very few strings attached. Ultimately it has taken until now for the banks to use the government hand-out as an incentive to modify home loans. Obama critics cite that banks should have never underwritten loans on a stated income basis, and that many home buyers should have known that the homes were beyond their means. Obama's plan has been very controversial, because many see it as using tax dollars to ultimately bail out these two irresponsible parties.

Almost a half million loan modifications were recorded in the second quarter of this year, and 10% of those involved reducing the principal. Even with this help, some homeowners just can not be helped. This is often a sign that the loan was irresponsibly approved and processed. A whopping 28% of the loans modified in the first quarter of 2008 were in default again within three months. And furthermore, those mortgages modified in the second quarter of 2008, 56% were in default again a year later.

The most common tactics in loan modifications have been to either reduce interest rates or extending the term of the home loan. These methods help homeowners without requiring lenders to lower the principal owed. The last resort for any bank is to write off some of the loan altogether, but this is even happening in a some cases. Bank's first try to modify loans by lowering the interest rate for qualifying borrowers. If that doesn't lower the payment enough then the bank may extend the term of the loan, which will lower the monthly payment even more.

Despite of the loan modification efforts of lenders, foreclosures still continue to rise. In a report last week, an estimated 12% of U.S. homes with mortgages will be foreclosed over the next couple of years. The reporting company said it doesn't expect that loan modification efforts will significantly ease the problem, mostly because so many people default again. Because of the rate of defaults after a loan modification, many believe that the federal governments involvement is just slowing the inevitable. In the end, all of the irresponsible home lending and borrowing will fix itself, but at the expense of government resources.