New York Fed: Principal Reductions Help Borrowers, Market

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Though the housing market is rebuilding, and has been for several months, many industry experts recognize that there is still a long way to go to full recovery. Now, a new study shows that there may be a way to more quickly boost the speed with which this improvement takes place.

Analysts have posited many ways in which the government and private sector can work to improve the housing market more quickly, and now it seems that one such option might be for banks to start reducing troubled borrowers’ loan principals, according to a new study from the Federal Reserve Bank of New York. In the last several years, mortgage delinquencies and defaults have obviously been a major problem in the housing industry, and exploring more options for relieving these instances of late payments is a point of hot debate.

But the New York Fed’s study found that in general, principal reductions can be just as effective in limiting the chance of default as reducing the interest rate on the mortgage in question, the report said. For instance, a 2-point reduction in the interest rate on such a loan can have the same effect as slashing an underwater borrower’s loan to value ratio to an even 100 percent from 135 percent. Meanwhile, those that cut rates by 4 points – which actually tend to be the fairly common, having been applied to about 20 percent of mortgages studied – would be roughly the equivalent of cutting a loan principal from 155 percent of the property’s value to just 80 percent.

“This illustrates the broader and important finding that our estimated effects are similar if we look at only a subset of borrowers in our sample who are severely underwater,” the Fed study said. “As we show, this is consistent with basic finance theory and goes against the intuition held by some commentators that once a borrower’s mortgage is sufficiently far underwater, it is always optimal for him to default.”

Home price improvements seen nationwide in the last several months have brought a large number of underwater home owners back to being right side up on their mortgages, but continued recovery is important to the many millions more who still face negative equity.

Image: epicharmus, via Flickr

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