Why Loan Modifications Often Don't Work

With a ballooning mortgage payment, Kevin Kroger had been trying for months to work out a deal with his loan servicer. But after several modifications, the Sioux Falls, S.D., homeowner found that he was even further behind on his payments -- and was growing increasingly worried about losing his home.

Fortunately, since August last year, Kroger’s been negotiating a deal that should allow him to stay put. Beginning next month, his loan servicer, HomeEq Servicing, will reduce his adjustable interest rate to 3% for two years. (The rate will then increase by one percentage point a year, up to 6% on year five.) The new modification will reduce his $1,300 monthly payment to $870.

It's a significant improvement from the three so-called forbearance agreements he’d received in the past year and a half. Those deals only added the past-due amounts to his monthly bill, at one point boosting his payment to as much as $1,800. “They make your mortgage payment bigger so you can catch up... and you can’t afford the original one,” he says. "[Now], I'll definitely be able to keep my house."

Not all homeowners are as lucky as Kroger. In fact, more than half (55%) of loans modified in the first nine months of 2008 were 30 days or more late within six months, according to the Office of the Comptroller of the Currency (OCC).

The problem? Even as lenders have become more willing to modify borrowers’ loans in the past year, many aren’t offering deals that borrowers can afford over the long term, explains Austin King, national director of ACORN Financial Justice Center, a New Orleans-based consumer group.

Here are five reasons why loan modifications fail.

Because many lenders add unpaid interest and fees to the loan balance, homeowners often walk away with more mortgage debt than they originally incurred. A study by Alan White, an assistant professor of law at Valparaiso University found that an average $10,800 was added to mortgages when they underwent a modification. The average such mortgage was $210,000.

Unfortunately, servicers that reduce loan principal are few and far between. In fact, just one company -- Ocwen Financial Corporation (OCN) -- accounted for 70% of all principal reductions, according to White’s report.

That may change should Congress pass pending legislation that will allow bankruptcy judges to reduce loan principal for homeowners in Chapter 13 bankruptcy protection. Such a move will provide an incentive for loan servicers to start reducing principal themselves. (Read more about this legislation here).

It should come as little surprise that with few lenders reducing principal — and most tacking on fees to the loan balance — nearly half of loan modifications (45%) actually resulted in increasing a borrower’s monthly payment, according to White’s study. “When you provide a modification that doesn’t actually reduce one’s payment, what do you think the odds are that they’ll re-default?” asks ACORN’s King.

Borrowers who owe more on their homes than they are worth have little incentive to stay there, even if their payments are lower. “I’m a big advocate for principal reduction because when people are underwater by hundreds of thousands of dollars, they walk away,” says Moe Bedard, the founder of LoanSafe Solutions, a Corona, Calif.-based company that works with attorneys specializing in loan modifications.

Desperate to keep their homes, many homeowners accept modification offers they can’t afford, according to Bedard. That shouldn’t be the case. “If you get a modification that you feel is not fair, counter that offer,” he says.

For a year and a half, Kroger couldn’t get his payments reduced because he was talking to the wrong people. “I was talking to customer service instead of the loss mitigation department,” he says. Even though customer services reps are typically the first people homeowners get on the phone, they aren’t authorized to modify a loan.

Worse, many homeowners seek help from so-called loan-modification brokers who charge upfront fees. Many of these firms are outright scams, taking the homeowner's money and doing nothing for them in return. For legit help, homeowners should contact a HUD-approved housing counselor in their area, whose services are free.