For borrowers who can no longer make their mortgage payments because of a loss of income or because of unexpected expenses, Federal Housing Administration (FHA) loan modifications can help avoid foreclosure and home loss. Although this process works well when interest rates have fallen since the borrower first took out their mortgage, the loan modification process, which lowers borrowers’ monthly payments, becomes more difficult if rates have risen significantly.

In any FHA modification, the loan servicer must buy the loan out of the Ginnie Mae pool, give the borrower a new modified rate, and resecuritize the mortgage. If interest rates have fallen, the borrower receives a lower rate on their modified loan. But if the borrower already has a low-rate mortgage and rates have risen, the old loan is bought out of the pool and the borrower is offered a modified loan at the current market interest rate, or else the issuer will incur a loss on the sale of the new mortgage. Taking, say, a 3.0 percent mortgage and raising the rate to the current 6.75 percent rate will not offer borrowers pay relief.

In short, the FHA’s existing tools—partial claim authority (the FHA can pay up to 30 percent of the loan amount as an interest-free loan to the borrower to lower the principal balance or mortgage payment) or a term extension (terms may now be extended to 40 years)—are inadequate to overcome the effects of higher rates. The FHA, Ginnie Mae, originators, servicers, and borrowers all agree there needs to be a better path forward, and they largely agree about what that path should look like. By leaving the loan in the mortgage pool—retaining its lower rate and reducing the payment amount for several years using the FHA’s partial claim authority—a borrower’s payment could be reduced without incurring serious costs to the servicer.

The FHA put out a draft of this concept—called the Payment Supplement Partial Claim (PDF)—on May 31, 2023, with comments due by June 30, 2023. Although this plan addresses this critical issue with an ingenious solution, the proposed mechanics are too cumbersome. Here, we propose two ways to fix the mechanics and fill a large hole in the FHA loss mitigation toolkit.

The Payment Supplement Partial Claim offers relief to borrowers but is operationally burdensome

In the draft of the Payment Supplement Partial Claim, the FHA outlines a framework for loss mitigation where the servicer first calculates the amount of the partial claim available to the borrower to reduce payments. If the borrower has no prior partial claim usage, 30 percent of the unpaid principal balance as of the date of default less the total arrearages would be available. Then, the servicer would determine how much of this partial claim is needed.

The servicer’s goal is to reduce the borrower’s principal and interest (mortgage) payment by 25 percent for years one through four and by 12.5 percent for year five, if feasible. In total, these reductions would constitute a 25 percent reduction for 54 months. Thus, the servicer would multiply the 25 percent monthly payment reduction by 54 and compare that amount with the remaining partial claim. If the partial claim amount is sufficient, the borrower would receive the full 25 percent payment reduction for years one through four and 12.5 percent in year five. If not, the FHA has proposed a waterfall to determine how much and for how long the servicers can reduce the payment. The servicer then collects the borrowers’ new monthly payments and supplements them with an advance on the partial claim each month, so that the investor, via Ginnie Mae, receives the full, original monthly payment.

In an early 2023 report, the Federal Reserve Bank of Philadelphia estimated that in 95 percent of cases, the partial claim amount would be sufficient. For borrowers, the amount of the partial claim they use will take the status of a second lien, making it repayable when the mortgage matures or is paid off.

Unfortunately, the mechanics undergirding this idea will most likely present significant difficulties for servicers, which would, at the minimum, delay implementation into 2024. With the current draft, servicers will not be paid the amount of required partial claim up front. Instead, the servicer must advance the funds, keep track of the amounts they are advancing on each loan, submit a claim for each loan (they can do so as often as every month), and track the disbursements. The more often the claims are submitted, the less money is required to be advanced, but the greater the administrative burden.

This program, as proposed, would produce a significant drain on personnel time, more than the proposed $1,000 of compensation to servicers can cover. The advancing will be particularly burdensome for smaller servicers, and it might reduce incentives to participate in the FHA program. And the waterfall process is more complicated than it needs to be for borrowers who do not have enough partial claim remaining to fund a 25 percent reduction for four years and the partial reduction for the fifth year.

Two proposals to simplify the draft Payment Supplement Partial Claim process

A more straightforward way to handle claim disbursement would be to have the servicer request the funds up front to cover both the arrearages and funds for future payments on each loan. The funds for future payments could be held in an escrow account until needed. But the Ginnie Mae prospectus requires that partial claim recoveries go directly to the bondholders, so this one-payment up-front disbursement is not possible.

Instead, the program could be redesigned so the servicer could submit two requests to the FHA: a partial claim to cover the arrearages and a request to prefund the loss mitigation program with the funds held in escrow until used. The FHA could then internally transfer the partial claim to fund the loss mitigation program. This solution eliminates the cumbersome monthly requests and the associated record keeping. Also, with this one-shot solution, the proposed $1,000 servicer compensation arrangements are more reasonable.

Another work-around would be to have the servicer submit a request for the partial claim to cover the arrearages and have the borrower request a second mortgage as a loss mitigation tool. The second mortgage would be funded from the partial claim, and the servicer would hold the funds in escrow. Although this solution could work, it’s less effective than the first, as the second lien could be considered a new loan origination and would need waivers from the Consumer Financial Protection Bureau to streamline the process.

In any case, the current draft of the Payment Supplement Partial Claim offers a solution for FHA loss mitigation when interest rates have risen, but it places a prohibitive administrative burden on servicers. As the public comment period continues, our research points toward work-arounds that could retool the draft to work for both servicers and borrowers. Doing nothing is not an option, as loan modifications are a critical tool for the families with lower incomes that compose much of the FHA borrower base.