Loan Problems: What Is Loss Mitigation?

Loss mitigation is a strategy used by lenders to limit the amount of potential losses they will incur when a loan defaults. For home loans, lenders may actually lose money if the house goes into foreclosure. This is possible if the value of the home has dropped or the market is extremely slow. Because lenders would like to avoid this problem, borrowers can negotiate to prevent foreclosure.

Upside down Mortgage

The term upside down mortgage describes a situation where you owe more on your mortgage than your home is currently worth. This is also called negative equity. This only happens when you buy your home at a market high and then the market drops sharply. Upside down mortgages became very common in housing markets that experienced big booms during the early 2000's then suffered sharp drops in the pending housing recession. When this occurs, a lender that forecloses on the home and sells it recovers less than the value remaining on the mortgage. It can also take a lot of time and money to sell the property, adding to the loss.

Lenders have to bear huge losses when the market drops. They have difficulty selling a home quickly and at a good price. A home valued at $300,000 may only sell for $230,000 if it is a foreclosure listing. While trying to sell the home, the lender will be paying maintenance fees, agent fees, taxes and other costs tied to the property.

Loan Forbearance

One option to pursue to mitigate losses for both the borrower and the lender is forbearance of a loan. In this scenario, the lender stops enforcing the loan contract in order to put off foreclosure. Payments continue to come due and interest is still charged. However, the borrower gets a chance to bring the loan current and avoid losing the property. This option only works if the borrower can somehow come up with the funds needed to stay in the home. Borrowers who are truly desperate will not really benefit from forbearance; they will only be putting off the inevitable.

Loan Modification

It may be possible for the lender to work out a different arrangement with the borrower that allows the borrower to still afford the property. Loan modification can extend the life of the mortgage and additional 5 or 10 years and leave the borrower with lower monthly payments. The lender can assess a higher interest fee and count on the payments for a longer period of time. The borrower benefits because he or she gets to remain in the property and keep any equity that may be built when the market recovers. This option will only be possible if both parties can benefit.