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New information from bank regulators shows that lenders are beginning to lower the principal amounts due on home mortgages for some struggling borrowers, a practice known as a Loan Modification. Lenders are betting that by taking the hit now they can improve their chances of being repaid. Over the next few years banks and other lenders will be sorting through thousands of loan modification applications. The approval rate of mortgage modifications in the second quarter of 2009 was 10%, which is a 7% jump from the first quarter, based on a Office of the Comptroller of the Currency Report.

Lenders now have the cash to justify mortgage modifications because of their balance sheets have strengthened with an influx of government handouts. The Obama administration announced plans to help underwater homeowners in March. The plans include financial incentives for lenders that modify loans. But, the plan involved handing over billions of dollars to troubled banks with very few stipulations. Ultimately it has taken until now for the banks to use the government hand-out as a justification to modify mortgages. Obama’s critics cite that banks should have never underwritten loans on a stated income basis, and that many home buyers should have known that the homes were beyond their means. Obama’s plan has been criticized because many see it as using tax dollars to ultimately bail out these two irresponsible parties.

Almost a half million loan modifications are on record in the second quarter of this year, and 10% of those involved reducing the principal. Even with this help, some homeowners are beyond help. This is often a sign that the mortgage was irresponsibly approved and processed. Over one quarter of the loans modified in the first quarter of 2008 were in default again within three months. And furthermore, of the loans modified in the second quarter of 2008, 56% were in default again a year later.

The most common tactics in loan modifications have been to either lower interest rates or extend the term of the home loan. These methods help homeowners without requiring lenders to reduce the principal owed. The last resort for any bank is to write off some of the loan altogether, but this is happening in some cases. Banks first try to modify loans by lowering the interest rate for qualifying borrowers. If that doesn’t lower the payment enough then the bank may extend the term of the loan, which will lower the monthly payment even more.

Despite of the mortgage modification efforts of banks, foreclosures still continue to rise. In a report last week, an estimated 12% of U.S. homes with mortgages will be in foreclosure over the next couple of years. The report said that loan modification efforts are not expected to slow or stop the problem, mostly because so many homeowners default again. Because of the rate of defaults after a mortgage modification, many say that federal involvement is just slowing the inevitable. In the end, all of the irresponsible lending and borrowing would have fixed itself quicker without government resources.

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