DEFINITION of 'Principal Reduction'

A decrease in the principal owing on a loan, typically a mortgage, for the purpose of lessening the outstanding principal balance on qualifying properties that have negative equity. Principal reduction is normally employed to prevent foreclosures on properties, which may be more costly to financial institutions than a reduced principal owed to them. As a result, principal reduction typically requires specific requirements in order for a homeowner to qualify, such as ability to commit to payments, to whom a mortgage payer owes the principal and whether the total balance owing on the mortgage is greater than the value of the property.

BREAKING DOWN 'Principal Reduction'

Typically, principal reduction programs are government-mandated, offered by firms such as Fannie Mae and Freddie Mac in order to relieve homeowners of a degree of debt-burden. Principal reduction is in essence debt relief, which counts as income on a tax return and thus is subject to tax. However, those who qualified for the Mortgage Forgiveness Debt Relief Act of 2007 were able to exclude some canceled debt on their primary residence while filling out their tax forms.

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