Mortgage principal reduction is an idea that could be helpful to or cause more default among borrowers. Some experts feel that widespread mortgage principal reduction may drive defaults much higher. Also, taking this step may tighten lending by forcing banks to offer “price protection” to borrowers. Moreover, the data shows there is essentially no difference in re-default rates among delinquent borrowers, given only payment reductions. And, those also offered smaller mortgages. About 40 percent of borrowers whose payments experienced cut between 20 percent and 40 percent after 12 months, defaulted again. This is regardless of whether they were more than 60 percent underwater. Or, they had home equity between zero and 20 percent.
On the other hand, there is the argument that policymakers should consider allowing non-delinquent borrowers to earn debt forgiveness. This is with on-time payments. It is likely that without a significant turnaround in home prices and employment, a substantial proportion of those loans that are deeply underwater will ultimately default absent an earned principal reduction program. Among subprime borrowers who received payment reductions of more than 40 percent in 2010, 19% defaulted after 12 months; if their reworked loans included a lower balance, while 27% fell behind again if they only received a lower rate. Borrowers are almost twice as likely to default again after the modification of a loan without reducing the principal balance.
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