What is a principal reduction?

Floating underwater home
Principal reductions, sometimes referred to as “cramdowns,” occur when a lender reduces a home mortgage loan’s principal to the appraised value of the securing property.

These somewhat mythical opportunities are what consumer advocates have been pleading banks and leading lenders to grant borrowers for years now. But unfortunately for struggling homeowners, lenders have been reluctant to do so.

When the 2008 housing collapse occurred, millions of homeowners saw their property values decline. Those declines were so intense, that the owners’ mortgage loans became more expensive than the total value of their securing pieces of real estate. This unfortunate financial situation became known as having an upside-down mortgage loan, or an underwater property.

The only way to lift a property out from the “underwater” depths is to either increase the property’s value or reduce the mortgage loan’s principal that was used to purchase the property. If the property’s financing is reduced to be equal with the property’s appraised value, then the property will no longer be underwater and the owner will no longer have an upside-down loan.

The best way for borrowers to avoid negative equity, despite the ups and downs of the economy, is to offer a large down payment and to only financing a mortgage loan that they can afford.

So why exactly don’t lenders hand out mortgage loan principal reductions? There may not be one correct answer to that question, but some speculate lenders’ fear of creating a precedent that millions of underwater homeowners would want to cash in on.

If lenders begin reducing the principal on properties for some borrowers but not others, there will be an endless supply of lawsuits filed against those lenders. But if principal reductions are given to everybody, millions and millions of homeowners will reduce their loans, and lenders will lose billions of dollars.

That’s billions of dollars that they’ve already lent out to homeowners, and billions of dollars they can’t exist without.

The burden would ultimately fall on the taxpayers to bail these banks out (yet again), or risk losing our largest financial institutions all together.

Until the government or our private lending institutions can devise a way to effectively grant principal reductions or actual and useful refinancing opportunities, our nation’s struggling mortgage loan borrowers will be forced to fight through this rising sea of negative equity.