As of the end of August 2022, 350,000 FHA borrowers were seriously delinquent. Some of these borrowers will regain their financial footing, cure their delinquency, and resume their monthly payments, while others will sell their homes. The remainder will need a reduction in their monthly payment to an affordable level to remain in their home. However, the combination of the mechanics of an FHA modification and a substantial rise in the mortgage rate has made modifications ineffective at delivering payment reduction.
To modify an FHA loan, the loan must be purchased out of the mortgage-backed security (MBS) at par, or 100% of the unpaid principal balance. Then, to re-securitize the modified loan without incurring a loss, the rate on the modified loan is set to the prevailing market rate so that it can be sold at par. Because most loans have a note rate well below the current market rate, increasing the rate offsets the payment reduction provided by the other modification steps. At current mortgage rates, modifying the typical seriously delinquent FHA loan would increase the monthly payment by 8%.
As a countermeasure, FHA should consider using a Payment Supplement to provide borrowers facing financial hardship in the current (and any future) high rate environment with substantial payment reduction. The Payment Supplement would reduce the borrower’s monthly payment without requiring that the loan be bought out of the MBS, thereby allowing the borrower to keep their below-market note rate. For the same typical seriously delinquent FHA loan, a Supplement could reduce the monthly payment by 25% for 6.5 years.
Without the Payment Supplement as an option, seriously delinquent FHA borrowers who cannot afford their originally scheduled monthly payment would have to choose between a Standalone PC that provides no payment reduction at all and a modification that increases their monthly payment, and many would either have to sell their home or lose it to foreclosure.