A mortgage allows someone to finance his home purchase with funds borrowed from a bank or other lender. After the paperwork is signed, monthly payments fall due, with a fixed or variable rate of interest charged on the remaining principal amount. If the borrower finds payments growing increasingly difficult to make, he may be able to change the terms of the loan with the lender. One method of doing this is through a deferred balance arrangement.
A borrower in financial trouble is bad news for the mortgage lender. Banks and mortgage servicing companies want to avoid the foreclosure process, which takes time and usually results in a portion of the original loan being written off as a loss. To avoid default and foreclosure, a lender may offer a loan modification that reduces monthly payments by reducing interest, extending the term of the loan, or deferring payment of a portion of the principal.
Loan modification is not the same as refinancing, in which the borrower contracts for a new loan. Modification basically means a reduction of the monthly payment to a manageable amount for the borrower. Each lender has a set of guidelines to decide a borrower's eligibility. In most cases, the home may not be in foreclosure, and the borrower must be facing some financial hardship, such as unemployment or steep medical bills.
The federal government's Home Affordable Modification Program sets more specific guidelines: the home must be owner-occupied; the mortgage must have closed before 2009; the borrower must have sufficient income to handle a modified payment; and the balance owing, for a single-family unit, may not be more than $729,750.
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Once the borrower qualifies, the usual approach is to calculate his monthly gross income, and then apply a reasonable percentage of that income to the mortgage payment. A loan modification set at 35 percent, for example, would require a payment of $700 if the borrower is earning $2,000 a month. A deferred-balance modification would continue taking interest payments in full while setting a portion of the principal aside until the modification expires or the loan reaches the end of its term, when the deferred balance -- without interest -- would fall due in a balloon payment. This borrower also must make the deferred balance payment if the loan is refinanced or the home is sold.
Other Modification Methods
A loan modification using deferred principal also is known as forebearance. It's more common than forgiveness, in which a lender simply reduces the principal balance with no expectation of repayment. Under the guidelines of the Home Affordable Modification Program, participating lenders -- backed by funding from the US Treasury -- must set a target of 31 percent of gross monthly income for qualified troubled borrowers, and follow a series of steps to reach that number. The first step is a reduction in interest as far as a floor of 2 percent; the second is extending the term of the loan up to 40 years. If the monthly payment still remains above the 31 percent level, the lender then may defer principal or forgive a portion of the loan.