The Urban Institute’s Laurie Goodman et al. have posted Government Loan Modifications: What Happens When Interest Rates Rise?. This brief is another product of the newly formed Mortgage Servicing Collaborative. This brief
examines the current loan modification product suite for government loans insured or guaranteed by the Federal Housing Administration (FHA), US Department of Veterans Affairs (VA), or the US Department of Agriculture (USDA). When a delinquent borrower with a government loan obtains a modification, the mortgage rate is typically reset to the prevailing market rate, which can be higher or lower than the original note rate. When the market rate is below the original rate, providing payment reduction becomes inherently easier and less expensive for the investor. Conversely, when market rates are above the note rate, providing payment reduction becomes more expensive and challenging, making it more difficult to cure the delinquency. This can result in more redefaults and foreclosures, larger losses for government insurers, and greater distress for borrowers, communities, and neighborhoods. In addition, most government mortgage borrowers are first-time homebuyers and minorities, who tend to have limited incomes and savings, making loan modifications all the more important. (1)
Given the recent upward trend in interest rates, this is more than a theoretical exercise. And indeed, the brief “explains why FHA, VA, and USDA borrowers who fall behind on their payments are unlikely to receive adequate payment relief when the market interest rate is higher than the original note rate. ” (3)
The brief outlines some options that could increase payment relief for those borrowers, including deploying a 40-year extended term and principal forbearance to reduce the monthly mortgage payment. The brief acknowledges that there are barriers to implementing the options it has identified but it also proposes ways to overcome those barriers.
As I had stated previously, the Mortgage Servicing Collaborative is providing sorely needed guidance through some of the darker corners of the mortgage market. This brief sheds some welcome light on an obscured problem that may cause trouble in the years to come.