How will mortgage lenders treat borrowers caught by Katrina? Speculations about this abound, some plausible, some ridiculous. This note lays out the alternatives, and their implications for both parties. I will illustrate them with an example.

The loan balance of the affected borrower is \$100,000, the rate is 6 percent, the loan has 300 months (25 years) to run, and the monthly payment is \$644.31. Five hundred dollars of this payment is interest and \$144.31 is principal. Assume the borrower needs a “payment holiday period” of three months.

Option 1: Add the unpaid monthly payment (\$644.31) during the holiday period to the balance, then recalculate a new payment. This is an absurd option because the lender would be penalizing the borrower rather than helping him/her. (I would never have mentioned it except that it has been mentioned to me.) The lender has a claim only on the unpaid interest, not on unpaid principal that would have been used to pay down the balance. Adding unpaid principal to the balance would be unconscionable.

Option 2a: Add the unpaid interest to the balance each month, then recalculate the payment to original term. In the example, the balance after three months would be \$101, 507 and the new payment would be \$654.02. Under this option, the borrower has a small payment increase to make up for the payment holiday. The lender loses nothing, though the risk of default is a little higher because of the larger balance.

Option 2b: Same as 2a except that the term is extended as necessary to leave the payment as it was. In the example, the payment would remain at \$644.31, and the term would extend to 311 months.

Option 3a: Add the unpaid interest to the balance at the end of the holiday period (3 x \$500= \$1,500), then recalculate the payment to original term. This differs from option 2 in not accruing interest on the interest shortfall during the payment holiday period.In the example, the balance after three months would be \$101,500 rather than \$101,507, and the new payment would be \$653.97 rather than \$654.02. These are trivial differences, costing the lender little, but that is because the payment holiday period is so short. Extend the required holiday period to 12 months and the cost of not accruing interest on the unpaid interest during that period would be substantially higher.

There is an important corollary to this difference between option 3 and option 2. The lender who selects option 3 because he wants to be perceived as a nice guy is going to be much more concerned about the length of the holiday period. The longer the period, the more it will cost him. In contrast, the lender selecting option 2 is kept whole regardless of the length of the holiday period, provided that the borrower doesn’t default. As a result, the option-2 lender might be more liberal about the length of the holiday period.

Option 3b: Same as 3a except that the payment is left unchanged and the term is extended. In the example, the term would again be 311 months.

Option 4: Defer repayment of the unpaid interest until the remainder of the loan balance is paid off. In the example, when the borrower has repaid the loan balance after 300 months, he would have another \$1,500 of unpaid interest to repay. In effect, the lender would be making an interest-free loan for \$1,500 for as long as the borrower has a balance. This is as absurd as option 1, and again I mention it only because it has been raised with me.

It is absurd because the value of the lender’s gift to the borrower would depend arbitrarily on how long the borrower has the loan. The \$1,500 that must be repaid next year is worth much less than \$1,500 repaid after 25 years. Lenders providing such a gift, furthermore, would have even more resistance to extensions of the holiday period than lenders who selected option 3, since such extensions would cost them more.

In my view, either version of option 2 would work best, perhaps with borrowers offered their choice. The advantage of option 2 is that it keeps lenders more or less whole regardless of the length of the payment holiday period. This is important because the holiday periods required are likely to vary widely for different borrowers.

The writer is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.

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