What Is a Principal Reduction?

A principal reduction is a decrease in the amount owed on a loan, typically a mortgage. A lender may grant a principal reduction to provide financial relief for a borrower as an alternative to foreclosure on the property.

Key Takeaways

  • A principal reduction reduces the amount owed on a mortgage to help a distressed homeowner make payments.
  • Principal reduction was common in the years after the 2008-2009 financial crisis, which was blamed largely on subprime mortgages.
  • An alternative to principal reduction is interest rate reduction.

Principal reductions were relatively common in the years immediately following the 2008 financial crisis when many homeowners across the nation found themselves owing more on their homes than they were worth in a depressed market.

Understanding Principal Reduction

The foreclosure process is devastating for a homeowner but it is expensive for a bank. Many homes stood empty for years after the financial collapse in 2008-2009.

The government-sponsored Home Affordable Modification Program (HAMP) was put in place to alleviate the problem, keep more people in their homes, and prop up the mortgage industry. The program financed loan modifications that reduced the principal of loans, reduced the interest rates paid on them, or extended the terms of the loans to bring them into line with the homeowners' ability to pay.

The program expired in 2016.

The Subprime Crisis

HAMP was aimed at alleviating a widespread problem caused by loose lending standards in the years previous to the financial crisis. Homebuyers were permitted and even encouraged to take out mortgages far larger than their incomes could support on the dubious grounds that they could always sell them as home prices continued to rise. The mortgages were "subprime," meaning the borrowers were unlikely to be able to repay them.

The lenders then sold those mortgages on to financial institutions which packaged them and resold them as investments in debt.

Then the defaults started rolling in. As home prices began to fall, other borrowers found themselves "underwater," meaning they owed more on their mortgages than the homes were worth.

The HAMP Solution

HAMP provided a framework that lenders could use for offering principal reductions to those homeowners and to others on the brink of foreclosure.

The Hardest Hit Program was also established during this time to provide aid to homeowners at risk of foreclosure. Fannie Mae and Freddie Mac sponsored HAMP loans, which helped banks manage the increased number of delinquencies and defaults on their books.

Qualifying for a Principal Reduction

One of HAMP's achievements was to provide guidelines for principal reductions that were likely to be successful. That is, they would allow homeowners to stay in their homes while proving less costly to the banks in the long run than evicting their customers.

The federal government still has a Making Home Affordable program with a mission of helping borrowers with distressed mortgages.

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 were unpaid principal balances of up to $729,750, and specific debt-to-income ratios.

The guidelines used 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 common following the expiration of the federal program in 2016. Standards for mortgages also have been considerably stricter.

While 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, with a mission of providing support for borrowers with distressed mortgage loans.