Editor’s note: This is Part 2 of a two-part series.
Distressed properties continue to be a major factor in the real estate sales environment. These types of transactions are fraught with problems that can be extremely costly to your business.
When you work with a distressed property situation you have to be unusually careful. Part 1 of this series outlined issues with your Realtor Code of Ethics obligations, responsibilities for agents around providing financial counseling, as well as issues with blanket indemnification and recourse vs. nonrecourse loans.
Regardless of whether you can participate directly in the loan modification, it’s still important to be aware of how these important tools work for your clients. (Please note the level of agent involvement in a loan modification varies dramatically from state to state. Check your state laws to determine what is legal in your area.)
1. Tread carefully
There are numerous pitfalls when dealing with a client who is seeking a loan modification. First, if you are attempting to obtain a short sale and the owner submits an application for a loan modification, the application will often stop the short-sale approval process.
Second, there are numerous loan modification scams that can trick both agents and consumers alike. Scams include fees for debt counseling, deeding the property to a third party so the third party can supposedly make the payments, grant deeds hidden inside loan modification lending documents, rental scams, and a host of others.
2. Lender loan modifications — great for the lender
There are four major types of loan modifications, many of which are a great deal for the lender and a lousy deal for the homeowner.
- Straight capitalization
In this type of loan modification, back interest is added to the loan amount and then re-amortized under the same terms as the original loan. The challenge here is that this type of loan modification requires higher payments. If a borrower is already struggling to make lower payments, how will she manage an even higher payment?
- Loan modification with a term extension
A term-extension modification extends the time the borrower has to pay off the loan. The theory is that this will lower the payments. The lender takes the delinquent amount, adds it to the current loan balance, and then re-amortizes the loan. At least in theory, this approach will lower the borrower’s payment while simultaneously eliminating her delinquency.
To illustrate, assume that a borrower has a $200,000 fixed-rate loan at 6 percent for 30 years. The loan has been on the books for five years. The borrower owes $15,000 in back payments and late fees.
The lender agrees to a loan modification by adding $15,000 in delinquencies to the current loan balance of $195,000. The lender will then re-amortize the loan for an additional five years (35 years total).
The monthly payment on the original $200,000 loan was $1,199.10 per month. The new payment on the $210,000 loan is $1,197.50 (35-year amortization). While this wipes out the delinquency, the lender picks up an extra five years of interest while the borrower gets a measly $1.60 reduction in her monthly payments.
- Step-rate loan modification
When a borrower does a step loan modification, the interest rate is adjusted to make the monthly payments more affordable. A step rate drops the interest rate by up to 3 percent for the first year. It then increases 1 percent per year until it returns to the original interest rate. This provides up to three years of interest relief and is more beneficial to the borrower than straight capitalization or a loan modification with a term extension. This approach is also very popular with lenders.
- Reduced-rate loan modification
This type of loan modification is usually difficult to obtain unless the loan is still with the lender that originated it. In a reduced-rate modification, the interest rate is lowered for the life of the loan rather than temporarily as in the step-rate loan modification. This type of loan modification is the most favorable to the borrower.
3. Borrower and agent beware
A loan modification often sounds like a good solution for the homeowner. Please advise any of your clients seeking a loan modification to be especially careful about agreeing to a trial modification.
According to Barb Van Stensel of Keller Williams in Chicago, her experience with trial loan modifications is that the lenders keep their existing note in place during the trial modification period. What she has observed repeatedly is that lenders who grant trial modifications take the reduced payment and report it as a delinquency.
In order to protect the borrower’s credit during the trial modification, Van Stensel recommends that you have your clients write a letter to both the bank and the loan servicer. In the letter, ask for an approval for a "non-report on the new newly adjusted trial loan modification."
It’s extremely important that the title company records this letter. This puts all parties on the notice. The report must also include the property address, the loan number, the lender, and the last four digits of the borrowers’ Social Security numbers. Van Stensel says, "Don’t accept a trial loan modification without this approval!"
If you work with distressed properties, make sure you’re up-to-date on what is going on with the type of property you are representing, what the pitfalls are, and that you have the appropriate professional advice from tax and legal professionals for you and your clients.