Of the 1.55 million US mortgage loans Black Knight estimates are more than 90 days past due, about half (718,000) belong to Federal Housing Administration (FHA) borrowers.
Most delinquent borrowers are in COVID-19 forbearance plans, but in the next few months, many will reach their 18-month forbearance limit. Although some borrowers may be able to resume their prepandemic mortgage payments, many will require loan modifications to reduce their monthly payments to levels they can afford.
On July 23, the FHA released its new loss mitigation toolkit, which simplifies the modification options for owner-occupants and allows for deeper payment reductions with less paperwork than current loss mitigation options. Our work shows that this streamlined process could reduce barriers to take-up and give more borrowers access to needed relief.
How the new waterfall works
Loss mitigation options are generally structured as a series of steps to give the borrowers the help they need at the lowest cost. If the first, lowest-cost alternative is insufficient, the borrower will move to the next option. This is referred to as a loss mitigation waterfall.
For borrowers who can resume their prepandemic payments, the servicer will bring the mortgage current by using the FHA’s partial claim funds to pay the servicer an amount equal to the borrower’s delinquency, including principal, interest, taxes, and insurance (PITI). Taxes and insurance are covered to the extent they are escrowed. The borrower will owe the amount of the arrearages as a second lien, payable when the mortgage is extinguished. This part of the waterfall remains as it was before, though it is now rebranded as the COVID-19 Recovery Standalone Partial Claim.
Borrowers who can’t resume their old payments are eligible for a loan modification. Previously, the FHA had a complicated waterfall for determining this modified monthly payment amount, depending on what the borrower could afford and whether the borrower was willing to provide documentation. The new loss mitigation waterfall streamlines this process, requiring minimal documentation (an attestation of hardship). It offers most borrowers a deeper payment reduction than they would have received without documentation and comparable with what they would have received with full documentation.
In the table below, we assume a delinquent borrower has a 30-year mortgage with an original loan amount of $300,000 and a mortgage rate of 3.5 percent, which equates to an original monthly principal and interest (P&I) payment of $1,347. Assuming monthly taxes and insurance cost $450, the total monthly PITI payment is $1,797.
Under the current loss mitigation waterfall, if the borrower does not provide documentation, they can qualify for a standalone loan modification or a combination partial claim with loan modification.
In the standalone loan modification, the missed PITI payments are capitalized into the loan amount, the term is extended to 30 years, and the rate is reset to the current Primary Mortgage Market Survey (PMMS) rate plus 25 basis points. If we assume this borrower was delinquent for 14 months, had an unpaid balance of $290,000 at the time of default, and was given a new rate of 3 percent, the new P&I payment would be $1,329, or just 1.4 percent lower—effectively unchanged—than the original P&I payment. This is because the increase in the loan amount largely offsets the benefits from the term extension and rate reduction.
If the borrower cannot afford this payment, the servicer could offer a combination partial claim and loan modification, in which case the partial claim is applied to the arrearages so the interest-bearing loan amount stays constant. The mortgage is then extended to 30 years, and the rate is reduced to PMMS plus 25 basis points. This reduces P&I by 9.2 percent in our example, still well below the typical 20 percent payment cut required for modification sustainability.
If the borrower needed a more significant payment reduction, the borrower needed to document income to be considered under the FHA Home Affordable Modification Program (FHA-HAMP) (PDF).
For those willing and able to provide income documentation, an FHA-HAMP modification would allow for use of the partial claim up to 30 percent of the loan amount to target a mortgage payment that was 31 percent of a borrower’s income or a 20 percent reduction in PITI (whichever was lower), subject to a minimum payment of 25 percent of a borrower’s income. In our example, the borrower can achieve the 20 percent PITI reduction, allowing for a mortgage payment of $988 per month and a PITI payment of $1,438.
The new COVID-19 Recovery Modification targets a 25 percent P&I reduction without the income documentation requirement, rather than the 20 percent PITI reduction with the income documentation burden under FHA-HAMP.
To achieve this, the partial claim is first used to cover the arrearages (though this modification caps partial claim use at 25 percent of the outstanding unpaid principal balance). The mortgage term is then extended to 30 years, and the rate is reduced to PMMS flat, or 2.75 percent in our example. At that point, if the P&I reduction is less than 25 percent, the remaining partial claim (subject to the 25 percent cap) is used to hit the 25 percent target payment reduction.
Here, the 25 percent P&I reduction target yields a P&I payment of $1,010 per month and a PITI payment of $1,460 per month—nearly the same as the FHA-HAMP option ($1,438), without the need for extensive documentation and using fewer partial claim funds ($67,671 versus $80,886). In certain instances, borrowers can receive more than a 25 percent P&I reduction if they cannot meet the payment with a 25 percent P&I reduction and have sufficient partial claim capacity remaining to reach the lower payment level.
Less documentation can lead to more take-up of relief options
Evidence suggests the FHA’s low-documentation modification will greatly improve the take-up rate and increase the number of successful modifications. We found that to be the case when we evaluated the Fannie Mae streamlined modification program—the take-up rate for modifications in which the borrower did not have to provide financial information was 44 percent higher than the take-up rate for full-documentation modifications. Although the streamlined modification failure rate was slightly higher, overall, the strategy increased total successful modifications by 34 percent.
This simple, intuitive framework will be easier to implement at scale than the old program, ensuring quick relief for borrowers exiting forbearance and giving homeowners unable to sustain their old payments a streamlined way to obtain a sizeable payment reduction.