What Is a Principal Reduction?

A principal reduction is a decrease in the amount owed on a loan, typically a mortgage. A lender may grant a principal reduction to provide financial relief for a borrower as an alternative to foreclosure on the property. Principal reductions were relatively common following the financial crisis that led to the Great Recession. Many homeowners across the nation found themselves owing more on their homes than they were worth in a depressed market.

How Principal Reductions Work

Homeowners who experience financial hardship may find it difficult and overwhelming to maintain their mortgage payments. Defaulting often results in legal foreclosure proceedings and the loss of the property if the arrears aren't cleared up. This process can be devastating for a homeowner, but it can also be very expensive for a bank. Lenders typically don't want to go through the costly and time-consuming process.

This was the case after the housing market collapsed during the 2007–2008 financial crisis and the resulting 澳洲幸运5官方开奖结果体彩网:Great Recession. The government-sponsored 澳洲幸运5官方开奖结果体彩网:Hﷺome Affordable Mod🐽ification Program (HAMP) was put in place to alleviate the pro꧑blem, keep more people in their homes, and prop up the mortgage industry.

The program involved principal reductions. It financed 澳洲幸运5官方开奖结果体彩网:loan modifications that reduced the principal of loans, reduced the interest rates paid on them, or extended the terms of the loans to bring them into line with the homeowners' ability to pay. Principal reductions not only allowed homeowners to stay in their properties, but they also staved ofꦬf the cost and headache of foreclosing, securing, and selling the home to recoup the money to pay off the mortgage.

Principal Reductions and The HAMP Solution

HAMP was aimed at alleviating a widespread problem caused by loose lending standards in the years previous to the financial crisis. Homebuyers were permitted and even encouraged to take out mortgages far larger than their incomes could support on the dubious grounds that they could always sell them as home prices continued to rise. The mortgages were subprime, meaning the borrowers didn't have very good credit histories.

The lenders then sold those mortgages on to financial institutions which packaged them and resold them as investments in debt. Then the defaults started rolling in. As home prices began to fall, borrowers found themselves "underwater," meaning they owed more on their mortgages than the homes were worth.

Qualifying for a Principal Reduction

HAMP provided a framework that lenders could use for offering principal reductions to those homeowners and others on the brink of foreclosure. The Hardest Hit Program was also established during this time to provide aid to homeowners at risk of foreclosure.

One of HAMP's achievements was to provide guidelines for principal reductions that were likely to be successful. That is, they would allow homeowners to stay in their homes while proving less costly to the banks in the long run than evicting their customers.

The guidelines included a net present value test, which helped lenders analyze the cost benefits of providing a borrower with a principal reduction approval. It also detailed eligibility requirements, among which were unpaid principal balances of up to $729,750 and specific debt-to-income (DTI) ratios.

Principal reduction offers became less common following the expiration of the federal program in 2016. The offer of a discounted payoff (DPO), where less than the principal due is accepted, allows lenders one alternative to resolve distressed debt issues. Standards for issuing new mortgages also have been considerably stricter.

The Bottom Line

Principal reductions help distressed homeowners avoid foreclosure and stay in their homes. To qualify, they were required to show they were experiencing financial hardship and, in some cases, owed more than the value of their homes. Federal government programs helped reduce the burden for borrowers until 2016 when these programs expired. Since these programs no longer exist, it's important to speak to your lender to see if it can work with you and help explore your options.