Rate freeze success: Devil's in the details

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NEW YORK (CNNMoney.com) -- If you can afford your adjustable-rate mortgage now, but not if it were to reset to a higher interest rate, increasingly there is help to be had. There's just one problem: Who decides if you can afford your mortgage?

"There's no uniformity. That's the problem," said Michael Shea, housing director of the Association of Community Organizations for Reform Now (ACORN).

And it's a problem that may not be resolved by the latest effort to help borrowers and mitigate the effects of the mortgage crisis on the economy. Hope Now - a coalition of government, industry and community groups coordinated by Treasury Secretary Henry Paulson - is reportedly working on a plan to freeze interest rates at current levels for five years for some borrowers with ARMs, although not all.

There are two basic ways to determine affordability. The company that services your loan may use one or both in combination.

The first is debt-to-income ratio. So, for instance, a monthly mortgage payment (including interest and taxes) may be deemed affordable if it does not exceed 36 percent of the borrower's gross monthly income and if total debt payments do not exceed 45 percent of income.

Some lenders making loan adjustments, however, will allow total debt to run as high as 55 percent of income, Shea said.

The second method is documenting an affordability budget. To see how much a borrower can afford to pay for housing, a servicer will compare a borrower's net income to his expenses plus required debts, said Bruce Marks, founder and CEO of the Neighborhood Assistance Corporation of America (NACA).

But servicers differ in what they consider to be "reasonable" to spend on necessities such as food or on non-recurring expenses such as an unexpected car repair. They also differ on what they consider to be "required" debt. So some servicers may consider a second mortgage, a car loan or a credit card balance as debt you need to pay off, thereby reducing the amount you have left to pay your primary mortgage, but others may not.

Servicers may use a cost-of-living index to determine if the amount a homeowner spends on food, transportation and other necessities is deemed "reasonable" but they don't all use the same index, and not all indexes are adjusted for family size or geography.

Consumer advocates like Shea and Marks would like to see servicers modify loans to a level that is affordable for borrowers such that they can afford their loans so long as they maintain their current income. "Your mortgage shouldn't send you into foreclosure," Marks said.

Sometimes, however, making a loan affordable can lead to unreasonable modifications from the investors' perspective, said Larry Litton, president of Litton Loan Servicing, who says he will have modified 50,000 loans this year - many of which were facing average payment increases of 25 percent.

As a servicer, Litton has to make the case to the loan's investors that while they will lose money on a modification, they would lose more if the home goes into foreclosure.

But there are steps in between - such as a short sale. In a short sale, the homeowner sells the home and if the sales price doesn't cover the remaining balance on the mortgage, the bank agrees to forgive that debt.

Marks and Shea also believe if a borrower's rate will be frozen, it should be done permanently rather than temporarily. "A temporary solution will not provide confidence to homeowners or investors that the subprime crisis will be addressed," Marks said, noting that a lot of homeowners in trouble today are having trouble despite being gainfully employed and should the economy slow down and jobs become scarce their affordability problem could worsen if rates are allowed to reset at some point in the future.

Litton disagrees. In the loans he's modified, he has frozen the interest rate for five years, the same time frame the Hope Now coalition is thought to be considering. A lot can change in the housing market during that time, Litton said, and five years is about the average amount of time homeowners stay in their homes before moving or changing loans.