Mortgage Principal Reduction: What It Is And How It Can Help You

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Key Takeaways

  • A principal reduction is a decrease in the amount you owe on a loan or mortgage.

  • Lenders may offer a principal reduction to a financially distressed borrower as an alternative to foreclosure.

  • Federal and state governments created temporary principal reduction programs in the years following the 2007–2008 financial crisis.

  • Most of those programs have expired, but there are alternatives such as forbearance, loan modifications, mortgage refinancing and equity-based products.

Are you struggling to keep up with your mortgage payments? Don't start worrying about foreclosure just yet. Mortgage principal reduction can help you get back on your feet.  

We'll explain mortgage principal reduction and why its popularity surged in the wake of the 2007–2008 financial crisis, only to drop in more recent years. 

We'll also list alternatives to principal reduction that may be more effective and easily accessible to homeowners today.

What Is a Mortgage Principal Reduction? 

A principal reduction decreases the amount a borrower owes on a mortgage. Lenders can sometimes grant principal reductions to distressed homeowners who are struggling to make payments and may be at risk of foreclosure.

Foreclosure is a lose-lose situation. It can be extremely traumatizing for a homeowner. It's also an unattractive prospect for banks, as the process is often costly, time-consuming and has low investment return.

Government Principal Reduction Programs

Principal reductions surged after the 2008 financial crisis when many homeowners suddenly found themselves underwater: owing more on their properties than they were worth. Let's do the math...

In part, that was due to lenient lending standards in the years leading up to the crisis. Lenders would allow – and even encourage – homebuyers to take out mortgages they could not afford, in the mistaken belief that they could always sell them later as home prices rose. 

Lenders would then sell those mortgages to financial institutions, which also resold them as investments in debt.

Eventually, the bubble burst.

As defaults began piling up and home prices started to fall, homeowners across the country found themselves underwater.

The government stepped in and created programs to help more people stay in their homes, and to help revive the mortgage industry.

The JPMorgan Chase Institute found that a 10% mortgage payment reduction reduced default rates by 22%.

1. Home Affordable Modification Program (HAMP)

HAMP was a federal initiative and part of the Troubled Assets Relief Program (TARP). It enabled loan modifications that reduced loan principal balances and interest rates, or extended loan terms. 

To qualify for HAMP, you had to have:

  • An unpaid balance of less than $729,750

  • A property that wasn't condemned or uninhabitable

  • A debt-to-income ratio (DTI) showing financial hardship

HAMP ended in 2016.

2. Hardest Hit Fund (HHF)

The U.S. Treasury set up the HHF in 2010 to aid the states most affected by the crisis. States had their own eligibility criteria, but all required that the home be the applicant's primary residence. HHF was available until the end of 2020.

  1. Principal Reduction Modification Program

This program was a one-time initiative by the Federal Housing Finance Agency which was available only to Fannie Mae or Freddie Mac borrowers. Eligible applicants needed to have an unpaid principal balance of $250,000 or less, and be at least 90 days in arrears. The program ended in October 2016.

4. Making Home Affordable

While HAMP has expired, distressed borrowers can still access the website of its parent program, Making Home Affordable. There, you can find resources on finding a housing counselor, avoiding scams and other helpful information.

Alternatives to Mortgage Principal Reduction

With government programs no longer available, you may need to explore alternative tools to help stave off foreclosure. 

Mortgage Payment Assistance

Principal reduction programs may no longer be available, but you may still qualify for general mortgage payment assistance through your lender. 

To qualify, your home needs to be at risk of foreclosure, and you need to show that you would be able to make the mortgage payments with the reduction. Note that most programs also require the property to be your primary residence, and some may have a cap on the amount you can owe.

Home Loan Refinancing

This option involves taking out a new, larger loan at a lower interest rate. This can enable you to pay off your existing mortgage while saving money on monthly payments and over the loan's lifetime.

Loan Modification

A loan modification is a change to the original terms of your mortgage. You must apply for a modification with your lender. They won't typically charge you for the modification, but it may hurt your credit score.

 Infographic showing the differences between cash-out refinancing and loan modification.

Mortgage Forbearance

Loan forbearance is a temporary pause on your monthly payments. This can help you go through a short-term rough patch. This is less and less an issue for American homeowners as the economy has experienced a surge in recent months. At the end of March, about 525,000 homeowners remained in forbearance plans, according to the Mortgage Bankers Association. That is far below a staggering 4.3 million affected in June 2020.Building Up Equity

If you're employed but underwater due to a drop in the housing market, consider staying in your home and building equity through regular repayment. By the time the economy recovers, you may have built sufficient equity that you can then leverage by selling the property, or by taking out a home equity loan, home equity line of credit or home equity agreement.

Home Equity Agreements (HEAs)

With a home equity agreement, you trade a percentage of the equity you have built in your home for a lump sum of cash. At the end of the term, usually 10 years, you sell the property, and the HEA provider gets a share of the proceeds. 

HEAs are not loans. There are no income requirements, monthly payments or interest rates, and credit score requirements are low. You also get to live in your home and enjoy all the benefits of ownership until the end of the term. Even then, you can buy the HEA provider out if you don't want to sell.

To qualify for a HEA, you need to have generated at least some equity in your home – usually 25%.

Struggling With Your Mortgage? Get Back on Your Feet with Unlock.

If you have a less-than-ideal credit score and good equity in your home, Unlock's HEA may be able to improve your financial situation.

See how it works here.