Why Loan Modifications Don’t Work: Distressed Borrowers Re-Default at Alarming Rates

Government programs have come under fire recently for their poor performance in terms of loan modifications. Data shows that over 70% of modified loans fall back into default as soon as the modification period ends. While it is important to explore the reasons people default on mortgages, it should also be noted that borrowers, whose principals were reduced were far less likely to re-default. This should show banks and the government that borrowers are either smarter than they thought or a bit less moral, depending on the perspective.

Reasons for Re-Defaults in Loan Modifications

The easiest reason to identify in a re-default is the lack of an appropriate modification plan. Borrowers that suddenly find themselves out of work today will have a host of issues to deal with as their savings deplete. A six month stay on payments will only delay the inevitable. As credit card debt, household maintenance and general life expenses pile up, they simply drown in debt. Six months later the prospect of paying their mortgage remains dim, if not complete dark, given their additional financial deterioration. These consumers should never be given a modification, but rather should pursue a short sale or foreclosure.

In addition to the above, borrowers that modify their loans are likely in a neighborhood with falling real estate prices and foreclosures. Foreclosures spread like wildfire because they lose their mystique and stigma when they become common place. Data shows that when one person in a neighborhood strategically walks away from a mortgage, the remaining homeowners are much more likely to do the same. In the context of loan modifications, foreclosures clearly influence their decisions. Once they see a neighbor or friend undergo a foreclosure, move to a nicer home and pay substantially less than their original mortgage, it becomes a little easier to let their own property go back to the bank.

People should also keep in mind the economy, while improving, has not created nearly enough steam in the form of job creation and consumer spending to merit a substantial change in many people’s current circumstances. This is, likely, yet another reason a loan modification comes up short. Too many borrowers find themselves in the exact same place they were before the loan modification, but out of options after the modification period has run its course.

Borrowers Need to Decide the Right Path

Borrower education represents the biggest problem with the entire modification process. Borrowers should force themselves to be realistic about their financial situation at the end of the modification period. Rather than looking at the modification period as a free opportunity to stay in their homes for six months, borrowers should be considering a modification or a short sale. Banks also need to be much more realistic when it comes to short sales. Short sales return 20% more to banks than foreclosures and provide a much shorter time to recovery.

Loan modifications continue to be the first tool in the lender tool belt. Borrower should examine short sales and principal reductions as an alternative to loan modifications.