When it comes to mortgages for distressed borrowers, there are options known as principal extinguishment, principal forgiveness, principal forbearance, and principal reduction. There are subtle differences involved.
Principal extinguishment has been granted by some mortgage lenders, particularly secondary lienholders. Principal extinguishment is a negotiated agreement between the lender and the borrower whereby the lender agrees to forgive the remaining debt and file a mortgage satisfaction piece. In other words, the lender tells the borrower that they no longer owe any money and the lien will be released.
The borrower can expect to receive a 1099C from the lender for the amount of the forgiven debt. The borrower may have to pay tax to the IRS on the forgiven debt.
Principal extinguishment is not the same as a principal reduction. Principal reduction involves the removal of some of the underlying debt, but the borrower will still be responsible for the remaining debt. In many cases, the mortgage lien will not be satisfied until the balance of the loan is paid in full. In other situations, the lender will release the lien yet still attempt to collect some of the remaining debt while offering to forgive the rest.
The federal government’s Making Home Affordable Program has provisions known as the Principal Reduction Alternative and the Second Lien Modification Program. On June 3, 2010, the Department of the Treasury issued Supplemental Directive 10-05 announcing a Principal Reduction Alternative (PRA) regarding first lien mortgage loans. On October 15, 2010, Supplemental Directive 10-14 provided further guidance. Under PRA, lenders are eligible for financial compensation whenever they reduce mortgage principal under the Home Affordable Modification Program (HAMP).
The Second Lien Modification Program, announced on March 26, 2010 in Supplemental Directive 09-05, provides financial incentives for secondary mortgage lenders for a full extinguishment or a principal reduction if the borrower’s first lien was modified under HAMP guidelines.
The guidance in the Supplemental Directives does not apply to loans owned or guaranteed by Fannie Mae, Freddie Mac, insured or guaranteed by the Veterans Administration (VA) or the Department of Agriculture’s Rural Housing Service or insured by the Federal Housing Administration (FHA).
The Federal Housing Finance Agency (FHFA), which oversees Fannie Mae and Freddie Mac, removed principal forgiveness as an option for distressed borrowers in 2012. FHFA's analysis revealed that taxpayer losses are reduced by principal forbearance, but not by principal forgiveness. In other words, FHFA does not wish to reduce the principal balance of a mortgage for a distressed borrower. Instead, they may consider forbearing some of the principal for a time. In other words, the principal would not be forgiven or eliminated, but deferred until later. Interest might not accrue on some of the balance for a time. Some lenders might charge a lower interest rate on the full principal for a short period of time so the borrower can get back on their feet.
Here are some examples of each. Imagine that Johnny owes $200,000 on his mortgage loan.
Principal Forgiveness refers to both Principal Extinguishment and Principal Reduction.
Principal Extinguishment: Johnny's $200,000 mortgage loan is eliminated by his lender. He now owes $0.00.
Principal Reduction: Johnny's $200,000 mortgage loan has been reduced in the amount of $100,000 by his lender. He now owes $100,000.
Principal Forbearance: Johnny's $200,000 mortgage loan has not been reduced at all. However, his lender will only charge interest on $100,000 for the next two years so Johnny can temporarily have reduced monthly payments.
About the Author: Tai A. DeSa is the Team Leader of the Keller Williams Real Estate office in Allentown, Pennsylvania. DeSa is a graduate of The Wharton School at the University of Pennsylvania. Prior to entering the real estate business, he served as an officer in the U.S. Navy. The purpose of Tai's life is to be a leader and writer, and to do insanely good things for himself and others.
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