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Reducing the amount struggling homeowners owe on their mortgages is proving to be a more effective way to prevent foreclosures than other methods, such as reducing interest rates or postponing payments, a new report finds. Only 12% of borrowers who received principal reductions re-defaulted in 2011, Amherst found. That's compared with 23% of borrowers who received mortgage modifications with interest rate reductions (but no principal reduction) and 30% who received forbearance, which postpones their debt repayment.
The success these principal reductions have had in turning delinquent borrowers back into paying clients has led many lenders to step up debt forgiveness on the loans in their own portfolios. So far this year, principal reductions have accounted for 40% of the modifications done by the banks, up dramatically from 25% in 2011 and 11% in 2010, according to Amherst.
The mortgage servicers cannot forgive debt on loans that are owned or backed by one of the two government-controlled mortgage giants, Fannie Mae and Freddie Mac however, and they are limited in what they can forgive on loans owned by investors.
Even more principal reductions will also result from the tripling of incentives paid to mortgage investors who participate in the Principal Reduction Alternative (PRA), part of the Home Affordable Modification Program. For each dollar investors -- the pension funds, municipalities and other buyers of mortgage-backed securities -- allow to be written off, they can get back as much as 63 cents from Treasury.
By April, 2012, the number of modifications started under Principal Reduction Alternative had jumped to about 83,000 from 67,000 in January. The potential for building equity in the home, which principal reduction revives, is a major carrot for homeowners, especially if they're underwater on their home.
The typical amount of debt forgiven in a principal-reduction modification is about $60,000, according to the Treasury Department. Meanwhile, the average amount that borrowers are underwater is about $70,000.