Years ago, before the recent market downturn, loan payment problems between lenders and borrowers were often referred to as “loan workouts” or simply as “workouts.” These were situations where the lender and borrower worked toward a realistic resolution of the borrower’s inability to pay their monthly loan obligations as they became due. In more recent months and years, these types of negotiations have become known sometimes as “loan modifications” or “short sales.” A “loan modification” is part of a workout process where a lender agrees to restructure the loan, with possibly a reduction or deferral in interest payments, and possibly even a reduction in the principal balance due. However, many lenders seem to resist principal reductions, and they seem much more interested in deferral or reduction of interest.
This makes economic sense for the lender. If the lender were to foreclose at a low property value, then the lender may give up a hundred thousand dollars or more in lost principal that it would never recover. However, if that same lender reduced the loan’s interest payment by a thousand dollars a month, then over a period of three years, that lender would only lose $36,000 because it would receive $36,000 less in interest payments than if the loan hadn’t been modified. If the market improves so that the property is worth the amount of the loan, then the lender is in a very positive position. Any reduced interest rate could be adjusted back to where it was before, and then the borrower could repay the loan at the higher interest rate. If the buyer can’t make the payments, then the lender can foreclose. If in three years the property is worth at least $36,000 more than it is today, then the lender is ahead. This is because the lender would receive either more at the foreclosure sale, or if the lender bought the property at the foreclosure sale, then the lender could turn around and sell the property for more than it could if it foreclosed today. If in three or five years the property is worth $100,000 more than it is today, then the lender is far, far ahead because it will recover much more when it forecloses in a few years. If a lender can defer interest payments instead of reducing the interest, then the lender is also ahead if the market improves and the borrower elects to keep the property. So the current lender reduction in interest rates may be an indication that lenders are hoping that the real estate market will improve so that lenders can foreclose, if need be, in the future with smaller losses.