Lower loan payments = fewer redefaults for homeowners

NEW YORK (CNNMoney.com) -- It should come as no surprise that fewer troubled borrowers will redefault if their loan payments are lowered in a mortgage modification.

Now, there's federal data that shows this is true.

Only 18.7% of borrowers who had their loans modified in the second quarter were delinquent three months later, according to a banking regulators' report released Monday. This compares to 30.7% of borrowers in the first quarter.

Why the sharp drop in redefaults?

Regulators attribute it to their March directive that urged financial institutions to make sure the loan modifications they do are affordable and sustainable.

As a result, the percentage of modifications that decreased monthly payments shot up to 78.3% in the second quarter, from 53.5% in the first quarter, according to the report issued by the Office of Thrift Supervision and the Comptroller of the Currency.

Before, many servicers just tacked late payments and interest onto the end of the loan, not actually lowering the amount owed. So borrowers who couldn't afford the loan before couldn't afford it after modification, either.

More than 60% of homeowners who received modifications in the third quarter of 2008 were delinquent once again a year later, the report showed. Only 42.7% of adjustments made during that quarter decreased payments.

Now, servicers are routinely lowering interest rates, extending the term of the loan and sometimes reducing the principal to make the loan more affordable.

"What this shows is if you reduce payments, you have a greater chance for sustainable modifications," said Bryan Hubbard, spokesman for the Comptroller's office.

The report's results do not cover the 80,400 trial modifications initiated under President Obama's foreclosure prevention program in the second quarter. That's because those adjustments are not counted until they become permanent.

Since those trials are only being converted to permanent modifications now, the first data that reflects the program's performance will be available in March, Hubbard said. But Monday's report "bodes well" for the president's plan, since it calls for payments to be reduced to 31% of a borrower's pre-tax income, he said.

Servicers are doing more to help people stay in their homes, assisting more than 680,000 borrowers in the third quarter, the report shows. That's up 68.7% from the second quarter. More people are getting modifications than foreclosures: There were 369,000 newly initiated foreclosures during the quarter.

Some 40% of the home retention efforts were trial modifications under the president's plan.

But the foreclosure problem still threatens to dwarf the actions servicers are taking. Only of every six people who were seriously delinquent or in foreclosure received a trial or permanent modification, the report said.

Also, servicers remain woefully behind in providing permanent help to borrowers in trial modifications. Only 4% of those in the trial period have been converted as of Nov. 30, according to the Treasury Department.

The lower redefault rate and increased home-retention initiatives were among the few bright spots in the 49-page report.

More homeowners -- particularly prime borrowers with the best credit backgrounds -- are falling behind in their payments.

Some 6.2% of mortgages were at least 60 days delinquent at the end of the third quarter, up 16.7% from the previous quarter and 73.8% from a year earlier.

But prime borrowers' delinquency rate jumped 19.6% from the previous quarter and 116.2% from a year earlier. Their rate stood at 3.6% at the third quarter's end. That's mainly due to rising unemployment and the weak economy.

Option adjustable rate mortgages, which are considered the next ticking time bomb in the housing market, are also performing worse than the overall mortgage sector. Some 16% were seriously delinquent, and nearly 12% were in the process of foreclosure.

Option ARMs allow homeowners to choose how much they want to pay each month, and the vast majority decide to pay a minimum amount -- even less than the interest due.

Also, the number of foreclosures in process topped 1 million for the first time. That's 3.2% of mortgages, up 9.4% from the previous quarter and 82.4% from the previous year.