In Part 2 of this article, I explained why the Net Present Value test prevents a loan modification with a principal reduction. In this part, I will give a detailed explanation of the TWO PART loan modification test and how NET PRESENT VALUE affects whether your loan modification is approved or rejected.

What most borrowers don’t understand is that a loan modification is more than just a simple adjustment to the loan which makes the payments affordable; it is a complicated financial analysis for the lender and the servicer. In fact, there is a two-part test that all loan modifications must pass in order to be approved by the lender (and qualify for government incentives). This is complicated and convoluted, but it’s what every borrower needs to know in order to understand why a loan modification might be doomed for failure before the process even commences.

1.     Front-End DTI: First, to qualify for HAMP (the Treasury’s “Home Affordable Modification Program”), the borrower’s current payments for housing debt (i.e. principal, interest, taxes, insurance and association dues) must be “unaffordable” which means that those payments exceed 31% of the borrower’s gross monthly income. This is known as the “Front-End, Debt-to-Income Ratio.” This is usually not a big hurdle because most borrowers in financial trouble are paying well in excess of that 31% threshold. However, some borrowers believe they need to show the lender that they have NO income. In that situation, the loan modification will be rejected immediately because the borrower needs to be able to show that a loan modification will lower the Front-End DTI to at least 31%. If the borrower has no income (or if the borrower artificially decreases his or her income), the lender simply can’t do anything to get the payment to be “affordable” (there are limits to the interest rate reductions and term extensions which prevent unlimited adjustments to reach affordability). Alternatively, some borrowers already pay less than 31% of their gross income toward their housing debt, but have so many other bills that they still can’t afford the mortgage payment. These borrowers also fail the Front-End DTI test because they are already under the 31% threshold (the lender doesn’t care that you are over extended on non-housing debt). So, as you can see, the borrower has a narrow window between making too much money and not making enough money, within which the lender could provide an adjustment to the mortgage (e.g. lower interest rate, extend term or reduce principal) which would transform the loan from unaffordable (i.e. greater than 31% Front-End DTI) to affordable (i.e. equal or less than 31% Front-End DTI). However, the evaluation doesn’t end here. This where the Net Present Value test comes in to kill off the most effective loan modification tool: the principal reduction.

2.     Net Present Value (NPV): Next, the lender must determine whether it will suffer a greater loss by providing a loan modification as compared to simply foreclosing on the home and selling it. The lender must figure out which option (modification vs. foreclosure) provides the highest Net Present Value to the lender. In both a modification and a foreclosure, the lender eventually recoups some of the money that was lent to the borrower. In a loan modification, the lender will receive monthly payments which include principal and interest (albeit, at a lower interest rate than originally contemplated) over a period of 30 or 40 years. An accountant can look at that stream of 360 (or 480) monthly payments and figure out what is it worth in “today’s” dollars (that’s called the “Net Present Value” of a series of payments). Alternatively, in a foreclosure, the lender will end up selling the property either at a public foreclosure auction or as an REO (bank “Real Estate Owned”), and, after paying the foreclosure and sales costs, the lender will have a lump sum of money which it can (hopefully) re-lend to a new borrower at current interest rates. Again, an accountant can figure out how much money the lender will receive as a Net Present Value from the foreclosure and sale. At that point, it becomes a simple mathematical calculation to determine whether the lender receives more money through a loan modification or by foreclosing and selling the property. That’s the Net Present Value Test. Here’s the problem for a borrower: If the lender has to significantly reduce the interest rate, or extend the maturity date of the loan, or even reduce principal, all in an effort to comply with the Front-End DTI test above (to achieve that 31% target), it becomes MORE LIKELY that a foreclosure will provide a greater recovery than a loan modification. If so, the lender cannot approve the loan modification and must foreclose and sell the property. It is this little known NPV Test that kills many loan modifications, and the borrower is not told why they don’t qualify.

    So, as you can see, in situations where the lender must reduce the principal balance of the mortgage to the CURRENT MARKET VALUE to make the loan affordable, it is almost a mathematical certainty that the loan modification will fail the NPV test.

    A loan modification is not as clear cut as all those TV and radio commercials make it sound. There are ways to counter the harsh result of the NPV Test. A skilled negotiator can actually make a difference, but more often than not, a modification is SIMPLY NOT GOING TO WORK for the borrower. You must take a very close look at the numbers before you waste time and money attempting a loan modification. Additionally, YOU SHOULD NEVER PAY ANYONE AN UPFRONT FEE FOR A LOAN MODIFICATION (CLICK HERE FOR THE DEPARTMENT OF REAL ESTATE WARNINGS ON LOAN MODIFICATIONS). The failure rate is so high that you are almost certainly throwing money away.

    Please contact us so we can explain the TWO PART loan modification test in more detail and how it applies to you and your mortgage. We do not charge for this consultation.


    Derik N. Lewis is a California real estate attorney and real estate broker. Derik graduated magna cum laude from Boston University School of Law. He has 20 years of real estate experience and has served as legal counsel for some of the world’s largest lenders. During the current real estate downturn, Derik is applying his knowledge and experience to help homeowners find successful alternatives to foreclosure. Borrowers facing default or foreclosure can get a skilled broker and experienced short sale attorney by contacting