This piece originally appeared in the February 2023 edition of DS News magazine, online now.
For almost 100 years, loan modifications have been utilized in the United States to adjust mortgage loans of individuals struggling to make their payments by: reducing interest rates, reducing their ongoing monthly mortgage payment, or even reducing principal balances.
Modification programs began during the Great Depression in the 1930s at the state level and transformed over the years into federal policy during the subprime mortgage crisis in the early 2000s.
Forbearance agreements raced onto the scene during the COVID-19 pandemic. Borrowers quickly found themselves in an unexpected financial situation with the future uncertain. Along with forbearance agreements, there was more help as mortgage interest rates fell to record lows in 2020 and 2021 during the pandemic. Swift actions by the Federal Reserve pushed mortgage rates below 3% and helped to keep them there.
Low interest rates coupled with a housing market boom gave hope that the housing market would survive and even flourish during the pandemic.
The narrative changed in 2022. With inflation skyrocketing, mortgage interest rates have surged to their highest levels since 2002. This has created a new difficulty, with millions of Americans still recovering from the fallout of the pandemic and needing assistance with their loans.
The challenge becomes, how can a borrower in distress be offered a loan modification that can modify the loan to a payment that the borrower can afford when high interest rates may cause the payment to go up?
Typically, the answer to help a borrower stay in their home and avoid foreclosure was to add the delinquent payments to the loan amount, extend the term, and adjust the interest rate on the mortgage to the current market rate. But because today’s interest rates are rising, a loan modification may no longer be the pathway to home retention. Loan modifications are particularly attractive for borrowers when interest rates are low, because the borrower can often obtain a lower monthly payment. However, when interest rates are higher, a loan modification may not be the answer the borrower is hoping for. Due to servicer and federal guidelines, some lenders are not able to approve modifications if the principal and interest payment is increased beyond a certain amount. Higher interest rates and amortizing the loan to account for the past-due balance may cause that payment to increase too much, thereby eliminating the option of a loan modification.
Before the financial crisis in 2008-2009, most borrowers faced with foreclosure would opt to file a Chapter 13 Bankruptcy case. A Chapter 13 bankruptcy would provide the borrower with an automatic stay that prevented the foreclosure from moving forward while the borrower proposed a repayment plan that would allow for the past due payments to be cured over time at 0% interest and to continue to make ongoing payments on the mortgage.
Christopher Jones, a bankruptcy attorney with Acclaim Legal Services, with offices in the Metro Detroit area, said, “Prior to 2008, Chapter 13 bankruptcy often presented the most realistic and beneficial opportunity for a borrower facing foreclosure to avoid the foreclosure and cure the default on the mortgage.”
After the financial crisis, many mortgage lenders and investors began offering loan modifications to distressed borrowers while interest rates fell.
While not all loan modifications were the same, many of them would bring the loan current, lower the interest rate, or provide for a fixed rate on adjustable-rate loans, and extend the term of the loan. The net effect for most borrowers would be a current loan with a lower payment and a lower interest rate, but for a longer term. For a borrower trying to save a home from foreclosure, the resulting loan modification processes offered a different path from filing bankruptcy. This has remained true, as interest rates have remained relatively low until recent actions designed to combat inflation began to reverse this trend.
In economic climates like we are experiencing now, Jones says a borrower faced with capitalizing the arrears and obtaining an interest at 7% or more, or double their current rate, may find “a Chapter 13 is a much more attractive alternative.” Jones explains, “the borrower can preserve the existing (and likely low) interest rate and cure the arrears at 0% interest over the term of the bankruptcy plan along with resolving other outstanding debt.” A Chapter 13 bankruptcy is not an easy task and can be an onerous process, but the benefit of getting the mortgage back on track may be worth it for a borrower trying to save their home.
Jones often analyzes the option of a loan modification vs. a Chapter 13 bankruptcy with his clients. “The starting point of my analysis is short-term affordability of each option. The second part of my analysis is the long-term financial implications of each option.” The interest rate is a crucial component of the analysis. Per Jones, “I’m seeing this more and more often with rising interest rates … and more borrowers are opting for Chapter 13 bankruptcy vs. the loan modification as a result. The increased interest rates under proposed loan modifications are affecting the short-term affordability and long-term net cost associated with the mortgage, making Chapter 13 the more attractive option.”
As lenders and servicers begin to navigate this new era in loss mitigation and default servicing, new and creative ideas will emerge to help borrowers at risk of losing their homes. But in the meantime, a Chapter 13 bankruptcy, if feasible, is a good alternative to stop the foreclosure and allow the borrowers to buy time and propose a repayment plan on their delinquent mortgage payments while retaining their locked-in low interest rate.