For hundreds of thousands of homeowners who are underwater on their mortgages, it's been a tantalizing question: Is there any way that our lender might agree to lower the amount we owe — not just the monthly payments but the principal debt itself?
Until now, the answer virtually always has been a resounding no. Lenders and investors were willing to cut interest rates, reschedule payments, even write off some late fees, but they were dead set against forgiving even a dollar of the principal balance owed. The Obama administration's loan modification programs have carefully sidestepped the subject as well, focusing on lowering troubled borrowers' monthly payments to more affordable levels rather than actually wiping out debt.
But the outlook for principal reductions may be on the verge of significant change. Bank of America recently unveiled the mortgage industry's first large-scale principal forgiveness program, potentially involving up to 45,000 underwater borrowers and $3 billion in debt write-offs.
Meanwhile, Treasury Department officials confirmed that the administration is examining debt forgiveness options as potential add-on features to its existing mortgage modification programs.
The program changes could be announced within the next few weeks, and if adopted by the industry could ultimately affect loan modifications offered by a substantial number of banks and mortgage companies.
Bank of America's new program targets borrowers who are deeply underwater — those with loan-to-value (LTV) ratios of 120 percent or more. This means they owe at least 20 percent more on their mortgage balances than the current market worth of their homes. There is no upper limit on how far underwater borrowers can be, but the program has a 30 percent maximum reduction of any principal balance.
Barbara Desoer, president of Bank of America Home Loans, said the program attempts to address the problems of the most "severely underwater mortgages with some of the highest rates of delinquency," and could "become an industry model for principal reductions" on a far broader scale.
The program targets three mortgage products that were wildly popular during the housing boom: subprime loans; payment-option mortgages with negative-amortization features; and "2-1" adjustables that offered teaser interest rates for the first two years, then converted into loans whose rates adjust once a year.
As part of its ongoing loan modification efforts, the bank will look to "earned" or phased-in principal forgiveness as the first step toward keeping an underwater borrower out of foreclosure.
Previously the bank — along with the rest of the lending industry — looked first to lowering a homeowner's interest rate and monthly payments. Under the new program, by contrast, severely underwater borrowers will be evaluated for principal reduction as the first step in a modification.
Here's how it will work, according to Bank of America officials: Say you're deeply underwater on a subprime mortgage you took out from Countrywide Home Loans, which was acquired by Bank of America in 2008. Say your mortgage balance today is $250,000, but your house is worth only $200,000.
If you meet certain eligibility requirements, the new program could reduce your balance by $50,000 and your new payments would be based on the lowered principal debt and possibly a lower note rate. This would be accomplished by the creation of an interest-free forbearance account covering a five-year period. Assuming you made regular payments at the modified, lower amount during the first year, $10,000 would be forgiven by the bank.
The same would be true for the second and third years. By that point, $30,000 of your principal debt would have been extinguished.
During the fourth and fifth years, the bank would appraise your property. If its value had appreciated in either year to the point where your LTV had dropped below 100 percent — you were no longer underwater but still benefiting from the lowered payments — there would be no forgiveness for that year.
On the other hand, if you remained underwater, you would receive the scheduled $10,000 per year principal reductions, extinguishing the full $50,000 during a five-year span.
For certain payment-option loan borrowers who are underwater in part because of the negative amortization features of the mortgage itself, the bank will forgive the negative amortization amount down to a 95 percent LTV level.
Officials said the phased-in forgiveness will include issuance of IRS 1099-C forms each year that principal is written off. This should assist homeowners in applying for federal income tax exemption for the forgiven mortgage amount.
Without fanfare, Wells Fargo, the country's largest volume lender, has also moved to selectively offer principal reductions for certain underwater payment-option loans.
If the Obama administration moves ahead with some version of the concept, principal forgiveness might well become a lifeline for a much wider group of homeowners who are now drowning in mortgage debt.
Kenneth R. Harney is a syndicated columnist with The Washington Post Writers Group. His e-mail address is firstname.lastname@example.org