What Is a Principal Reduction?

A principal reduction is a decrease granted toward the principal owed on a loan, typically a mortgage. A principal reduction can be obtained to decrease the outstanding principal balance on a loan and provide relief for a borrower. Principal reduction is normally deployed to prevent foreclosures on properties, which may be more costly to financial institutions than a reduced principal owed to them. Principal reductions were commonly offered following the 2008 financial crisis to help support distressed borrowers.

Understanding Principal Reduction

Principal reductions on mortgage loans were heavily issued from 2009 to 2016 when the government-sponsored the Home Affordable Modification Program (HAMP). HAMP was launched by the government to help support the mortgage industry following the 2008 financial crisis. Loose standards for credit products and specifically mortgage loans broadened the scope of lending to include a wider range of borrowers in the subprime category. These borrowers subsequently reported high default rates and significant challenges in making timely payments. Due to effects on the real estate industry, many borrowers also saw their mortgages incur negative equity with loan values higher than available market resale values. HAMP was instituted to help make homeownership more affordable across the country by providing a framework that lenders could use for offering principal reductions and principal reduction programs.

Home Affordable Modification Program

HAMP was part of a broad effort instituted by the government to help provide for recovery from economic effects caused by the 2008 financial crisis. HAMP was created through the Making Home Affordable Program, which was established under the Troubled Asset Relief Program as part of the Emergency Economic Stabilization Act of 2008. The Hardest Hit Program was also established during this time to provide aid to homeowners at risk of foreclosure. HAMP was in effect from 2009 to 2016. It was utilized by banks and lending institutions across the country. Fannie Mae and Freddie Mac also sponsored HAMP loans, which helped banks manage the increased number of delinquencies and defaults.

Qualifying for a Principal Reduction

The Making Home Affordable Program Handbook provided guidelines for lenders in analyzing and approving HAMP principal reductions. The Making Home Affordable Handbook included a net present value test, which helped lenders analyze the cost benefits of providing a borrower with a principal reduction approval. It also detailed eligibility requirements, among which included loans originated on or before January 1, 2009, unpaid principal balances of up to $729,750, and specific debt-to-income ratios.

The guidelines utilized in the Home Affordable Modification Program set standards for banks that they could use when considering future principal reduction approvals. Principal reduction offers became less popular following the expiration of the HAMP in 2016; however, they are still an option that national banks can turn to in the process of a mortgage foreclosure. While the HAMP has expired, the Making Home Affordable Program continues to be an initiative of the U.S. Department of the Treasury and the U.S. Department of Housing and Urban Development, providing ongoing support for borrowers in distressed mortgage loans.