Income Ratios, the HAMP Modification Waterfall, and Your Loan Modification Payment
The Home Affordable Modification Program (HAMP) uses the term “waterfall” to describe the four sequential action steps a lender must take to arrive at a monthly mortgage payment for homeowners attempting to modify their loans. The target payment is one that supports a 31% “front-end” debt-to-income ratio. Lenders will initiate the modification waterfall once they determine that a loan meets the HAMP eligibility criteria. In order to arrive at the magic number (31%), lenders must rule out or exhaust the possibilities in each tier before moving down the waterfall to the next tier.
First things first: How do lenders arrive at debt-to-income ratios?
A debt-to-Income ratio (DTI) is the percentage of gross income that is applied toward paying a borrower’s recurring (monthly) debt. HAMP uses two different types of ratios: Front-end and Back-end.
A front-end DTI is considered a “housing ratio”. It includes a borrower’s monthly principal and interest payment, along with 1/12 of yearly property taxes and insurance (PITI) and any Homeowners Association dues if applicable.
A back-end DTI includes the front-end ratio liabilities plus any other recurring debt, such as second mortgages, car payments and credit card payments. Lenders arrive at each corresponding ratio by dividing the sum total of a borrower’s monthly payments by the borrower’s gross monthly income.
Here is an example of how a lender would determine front and back end ratios
Front-end Debt-to-Income Ratio (DTI):
- Monthly Gross Income- $4000
- First lien (principal & interest)- $1500
- Property Taxes- $200
- Homeowner Insurance- $75
- HOA dues- $200
$1975 / $4000 = 49.38% (front-end DTI)
Back-end Debt-to-Income Ratio (DTI):
- Monthly Gross Income- $4000
- Front-end DTI- $1975
- 2nd mortgage- $300
- Car loan- $350
- Credit cards: $300
$2925 / $4000 = 73.13% (back-end DTI)
In order for borrowers to qualify for HAMP, their front-end ratios prior to the modification must be greater than 31%. Each lender’s objective will be to find a payment that will maintain front-end ratios at 31%. HAMP doesn’t have a cap on back-end ratios, which means that borrowers can get approved for a loan modification even when they have a significant amount of debt. To safeguard against delinquent modification payments, borrowers with back-end ratios of 55% or higher must agree in writing to obtain HUD approved credit counseling as a condition of receiving permanent modification
The HAMP Modification Waterfall
The following are the steps every lender participating in the HAMP program must take in order to arrive at a modified loan payment.
Step 1- Capitalization- A lender will calculate the sum total of any mortgage payments due (principal and interest); any property taxes and insurance (escrow advances); and any out-of-pocket servicing expenses during the time a borrower’s mortgage loan is in default. The sum total of these figures will be added (capitalized) to the outstanding principal balance. Late fees and servicing charges cannot be included in the capitalization amount. The new loan balance will be used in steps 2-4 of the modification waterfall.
Step 2- Interest Rate Reduction- In step 2 of the modification waterfall, a lender will reduce the interest rate on a borrower’s mortgage in increments of 0.125 percent (1/8 percent). The goal is to get the monthly payment as close to the 31% front-end DTI while staying at or above 2.0 percent interest, which is the lowest possible rate allowed for HAMP modifications.
The varying combinations in the amount of income and liabilities is the reason behind some borrowers qualifying for that coveted 2% initial rate and others ending up with higher initial interest rates.
Step 3- Term Extension- If the 31% front-end ratio is not accomplished with step 2, a lender will proceed to extend the term of a borrower’s loan. HAMP program guidelines allow a lender to re-amortize a borrower’s mortgage loan by up to 40 years.
In order to arrive at the 31% front-end DTI, a lender can only increase the term of a borrower’s loan by one-month increments. A lender will add one month to the term of your loan and see if that additional month will yield the target payment. If the ratios are still too high after adding one month to the term, the lender will add another, and then another, and so on until the target payment is reached or the term is maxed out at 40 years.
The new amortization period would begin on the “modification effective date”, which is the day the first permanent modification payment is due. Therefore, if a loan is re-amortized to forty years, the modified loan would have a term of forty years beginning on the date a borrower’s loan modification becomes permanent. If a borrower made payments on his mortgage loan for ten years and then modified with a term extension to forty years, that borrower would be paying on his loan for a total of fifty years.
If step lowering the interest rate to 2 percent and extending the term of the loan by 40 years doesn’t yield the 31% targeted housing ratio, a lender can proceed to step 4 of the modification waterfall.
Step 4- Principal Forbearance- If a lender still cannot arrive at the target mortgage payment after applying steps 2 and 3, your, that lender will provide a principal forbearance. The amount of the principal forbearance will result in a balloon payment due at the time a borrower sells his property, pays off his loan or at the end of the modified loan term. Principal forbearances are interest-free and are not subject to amortization.
It’s important to keep in mind that lenders are not obligated to modify loans. Lenders will use the Net Present Value testing results to determine if the modification terms a borrower qualifies for under HAMP are acceptable and meet the lender’s specific criteria.
Just so you know:
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