A workout loan allows mortgage borrowers to avoid foreclosure (or a default) through loan modification. Loan modifications that can turn a delinquent mortgage into a current workout loan include re-aging, extension, deferral, renewal, and rewriting. Workout loans aim to prevent foreclosure and to benefit both defaulted or at-risk borrowers and their lenders.
An important principle of preparedness is to plan for the worst-case scenario. But being fully prepared for the worst that could happen isn’t always practical. Particularly in the most expensive real estate markets, such as in California, achieving homeownership may require assuming the worst-case scenario won’t happen.
When bad things happen to good people with mortgages, workout loans offer a solution. Borrowers in distress may avoid foreclosure and keep their homes by persuading lenders to alter mortgage terms. This article will describe the types of modifications involved in workout loans, note a few key principles for making workout loans work, and illustrate it all with a hypothetical example.
What is a workout loan?
When you work things out with your mortgage lender by arranging new terms that make it possible for you to get current and avoid foreclosure (or default), the altered loan that results is a workout loan. Workout loans are a type of loan modification. The arrangement that turns a defaulted or at-risk loan into a workout loan is a loan workout.
Who can arrange a loan workout?
You will hear about workout loans most often in the context of home mortgages. But a business having difficulty meeting commercial mortgage obligations may also arrange a loan workout. Technically you could get a workout loan for any type of loan, but you are unlikely to hear the terms “workout loan” and “loan workout” applied to loans other than residential and commercial mortgages.
You will hear terms like “debt workout program” and “workout arrangement” applied to other types of loans, though. And, since marketers are always repurposing, modifying, and inventing terms to add punch to their copy, you might in the future see references to “workouts” of other sorts equally unrelated to your local gym.
Workout loan VS refinance
Every workout loan will work out a new arrangement with your lender. But not every new arrangement with a mortgage lender qualifies as a workout loan. For instance, a mortgage refinance is not a workout loan. This doesn’t mean you’ll never see refinancing listed among workout loan options on the web, though. The right mortgage refinancing can solve the same problems a workout loan solves. So, lenders naturally want anyone considering a workout loan to also consider refinancing.
5 types of workout loans
In 2020, the National Credit Union Administration (NCUA) added rules on “Capitalization of Interest in Connection with Loan Workouts and Modifications” to the Code of Federal Regulations. While the rules specifically guide credit unions, businesses referring to “workout loans” and “loan workouts” will usually have these same loan-modification categories in mind. The NCUA rules identify five types of mortgage modifications as workout loans:
If you’ve heard of debt collectors re-aging accounts to justify collection efforts past the legal statute of limitations, forget about that for now. Workout loan re-aging benefits the borrower. It sets the borrower’s overdue account to current status without collecting the total amount of principal, interest, and fees that the borrower would have to pay to bring the account current under the original loan agreement. This might involve the lender writing off some debt, in which case the benefited homeowner could owe additional taxes.
This moves back the loan maturity date by some number of months, re-amortizes the mortgage over the new term, sets the account status to current, and probably charges extension fees. The NCUA requires institutions under its jurisdiction to charge such fees up front, not add them to the loan balance. A common purpose of extensions is to lower the monthly payment. Adding fees to the loan balance would work against this.
To defer is to postpone. This allows skipping payments originally agreed to for some number of months. In its rules, NCUA requires that a deferral postpone payments without altering any other loan terms “including maturity.” This means that deferred payments must be made up at or before the original loan maturity date.
Though Fannie Mae is no credit union, it confirms that this same rule applies to deferrals on loans that it owns, specifying that deferred payments are “due with your last mortgage payment or earlier if you sell your home, refinance, or otherwise pay off your loan.”
Though the NCUA specifically excludes new loans from workout loans, mortgage renewal sounds very much like a new loan. If you reach your mortgage’s maturity date but still owe principal, mortgage renewal takes you back through the underwriting process to establish terms for a new period of monthly payments and new maturity date. NCUA notes that this “renewed” loan is “generally at [the mortgage’s] outstanding principal amount and on similar terms.”
Does the “generally” part of this description mean you could use a renewal as a way to pull some equity out of your home by borrowing a little extra, like with a cash-out refinance? That would be nice, but will a mortgage lender want to lend you even more money when you couldn’t satisfy the requirements of the first loan it gave you?
The more likely implication of the “generally” here is that a distressed homeowner might get the lender to write off part of the outstanding debt. A lender agreeing to a loan workout does so hoping for a better total return than would be gained through foreclosure, so convincing your lender to write off a portion of your debt could be a hard sell. Nevertheless, it’s possible. Should it happen, remember that any canceled debt will affect your tax liability.
Mortgage renewal abroad
In places like Canada, mortgage loans often have maturity dates that fall far short of the date when you would pay off the mortgage at the agreed-to monthly payment amount. Basically, these mortgage contracts expire at predetermined renewal dates. On those dates, you must renew your mortgage at the best terms then available or pay off the full remaining principal. Curious readers may review what the Canadian government has to say about this.
U.S. mortgage renewal
In the United States, mortgage maturity date and payoff date are normally the same in a mortgage contract. You sign up for a 30-year, fixed-rate mortgage, for example, committing in advance to make monthly payments of a certain amount over 30 years. As long as you meet your contractual obligations, you shouldn’t have to deal with mortgage renewal.
If you miss enough payments to invoke your mortgage agreement’s acceleration clause, however, the situation changes. By defaulting on your loan, you essentially bring the loan to maturity before its time. While the NCUA treats a mortgage renewal as a new version of the original mortgage, it bears a relationship to the original mortgage not much stronger than the relationship a man living today bears to a person he claims he was “in a past life.” Loan renewals are new loans in all but name.
You might also find yourself in a mortgage-renewal situation if you get a mortgage loan with a balloon payment due at maturity. Since this loan matures with principal outstanding, some borrowers will find they haven’t saved enough money to make the final payment. New loan arrangements at the conclusion of balloon mortgages typically receive the “refinance” label rather than the “renewal” label, however.
A mortgage loan rewrite makes significant changes to original loan terms. This may include a different interest rate, altered amortization schedule, new maturity date, and different monthly payments. A rewritten mortgage, in other words, may only resemble your original loan in that it is secured by the same property and has the same lender.
The principal you owe will likely also be the same. For one thing, a lender isn’t likely to loan you extra if you’ve already gotten in arrears on your original loan amount. For another, your difficulty meeting you original obligation suggests you won’t have cash available to pay off a big chunk of principal as you commit to this workout loan.
Your principal would change if you convinced your lender to cancel a portion of it, of course. But will your mortgage provider think keeping you out of foreclosure is worth the price of writing off some of your debt? If you successfully pay off your workout loan with the reduced principal, will that earn your lender a better return than foreclosure? If the answer is “yes,” your lender might consider the write-off.
Synonyms and an exclusion
In addition to excluding new loans, including refinancing, from workout loans, the NCUA excludes “borrower retention programs.” This can be confusing because another of the many terms you’ll hear used as a synonym for “workout loan” is “mortgage retention program.” On the subject of synonyms, others you’ll hear include “workout agreement,” “home retention program,” and, as already noted, “loan workout.” So, how is a borrower retention program not a workout loan?
The NCUA notes that credit unions can use workout loans to help borrowers facing temporary financial difficulties. Some examples of qualifying difficulties that NCUA offers are medical emergencies, job loss, and such family-related challenges as a family member’s death. The bottom line is that workout loans are to help borrowers with difficulties.
A borrower retention program, in contrast, might simply aim to avoid losing borrowers to other lenders through refinancing at better rates. Borrowers eligible for the program may all be current and not at obvious risk of default. A borrower with no missed payments and able to keep paying down an existing loan balance does not need mortgage modification to avoid default. Though all borrowers welcome improved loan terms, only those with problems to work out can get workout loans.
A caution for retention-program planners
By the way, if you are a lender planning a borrower retention promotion with a lower interest rate, make sure you run applicants back through the underwriting process. In 2007–2008, Downey Financial Corp made news for a borrower retention program that failed to do so.
The Downey program lowered rates for approved borrowers without taking their loans back through underwriting. The rates granted were in line with then-current rates for new borrowers. But failure to re-underwrite the loans made it impossible to prove that the rates granted retention-plan participants matched market rates for like-qualified new borrowers. As a result, the retention-program loans had to be classified as troubled debt restructuring (TDR) loans to accord with Generally Accepted Accounting Principles (GAAP). This kind of thing does not look good on your corporate balance sheet.
An example that highlights the principles of successful loan workouts
Clearly, a workout loan can involve a wide variety of mortgage modifications. Many arrangements that allow distressed borrowers to avoid foreclosure qualify as workout loans. Let’s see if we can get a better handle on this with a hypothetical case.
Everything started out OK
Your mortgage is a 30-year, fixed-rate (5% APR) loan of $300,000. You made your $1,610.46 monthly payments diligently for exactly six years. A generous cousin agreed to cover all the extra charges that would normally be added to your monthly payment, such as escrow funds to pay your property taxes and home insurance, so we can ignore those.
But now you’ve missed payments
After your last payment of year six, you had a remaining balance of $263,835.05. You’ve missed the first two payments due in year seven and just received a letter informing you that you can reinstate your mortgage by making up these arrears payments of $3,220.92 plus a reinstatement fee of $779.08. Your bank urges you to send in this $4,000 before or along with your payment of $1,610.46, due in two weeks. Your total liquid assets of $1,700 fall a little short of this $5,610.46 requirement.
Though you’ve always managed your finances responsibly, you had some unexpected medical expenses, which this article cannot describe due to HIPAA. Those have been taken care of, and you’re ready to get back to making your monthly mortgage payments. Is there any hope?
Sadly, you’ve already violated the first principle of successful loan workouts. You should have gotten in touch with your lender as soon as you incurred those medical expenses. For your reference, here are the principles you should apply if you need a loan workout to avoid foreclosure:
Principle 1: inform your lender you are having problems sooner rather than later
Lenders do not relish the idea of foreclosure. They strongly prefer for you to repay your loan and save them the hassle and risk of foreclosing. They care most about making a profit, of course, but they know from experience that many borrowers in difficult situations can work things out and make them a better profit in the end than foreclosure.
Even so, your failing to contact them as soon as you realize you have a problem could make them distrust you or think working with you is too risky. Either you didn’t care enough about making good on your debt to keep them in the loop, or you have such poor judgment and financial awareness that you couldn’t foresee that your medical expenses were going to pose a problem. Neither option makes lending to you sound like a good investment.
Principle 2: Be flexible and forthright, not entitled
Be clear about your financial situation and the workout terms you would most like. But don’t act as though you’re entitled to a workout arrangement on your terms. For a loan workout to happen, both parties must feel they are gaining more than they are losing.
The fact that your difficulties are due to a medical problem that wasn’t your fault does not change the terms of your mortgage contract. When you agreed to it, you knew unexpected things could happen and took on the risk voluntarily. You have no right to demand, and your lender does not have an obligation to give you, a workout loan. Now that you are in default, your lender has a right to demand full payment and then foreclose if you fail to pay.
You are asking for a favor and trying to persuade your lender that granting it will prove more profitable than foreclosure. Keep this in mind and act accordingly. If you do, you may get a deal you can live with.
Principle 3: Be ready to for chances on your taxes and credit
As it happens, your lender has proposed a workout agreement with the following terms:
- The new maturity date is 30 years from the first of next month
- $500 upfront fee
- New APR of 5.5%
- No loan forgiveness, sorry
This revised loan for your outstanding balance results in a new monthly payment of $1,498.03.
On the positive side, this loan doesn’t increase your tax liability by canceling part of your debt. On the negative side, this loan does make you pay your full debt. Also on the “positive” side, you will have a bigger mortgage interest deduction. In year six of your prior loan, you paid $13,645.31 in interest. In year one of your workout loan, your interest payments will total $14,422.21.
A mortgage workout arrangement could hurt your credit. In fact, when you check your credit report, you find that your missed mortgage payments affected your credit even before your loan workout went through. On the bright side, a foreclosure would have hurt your credit even worse.
- Workout loans allow borrowers to avoid foreclosure by modifying mortgages.
- A loan workout or workout agreement turns a defaulted or at-risk mortgage into a workout loan.
- A workout loan may involve re-aging, extension, deferral, renewal, or rewriting.
- Some workout loans look more like new loans than modified versions of the loans they replace.
- If a workout loan includes canceling some debt, the forgiven debt will affect the borrower’s taxes.
- Mortgage refinancing can solve many of the same problems that workout loans solve, making it a viable alternative for some.
- Lenders are not obligated to offer workout loans and not all lenders do.
- You can maximize your chances of workout loan success by adhering to these three principles:
- Inform your lender you are having problems sooner rather than later.
- Be flexible and forthright, not entitled.
- Be ready to affect your taxes and credit.
More to learn about home-purchase financing
Workout loans help you retain ownership of a home you’ve already purchased. But what about buying the home in the first place? Two interesting ways to help make a home purchase happen are the following, each with its own SuperMoney article: bridge loans and asset-based mortgages.
View Article Sources
- Acceleration clause — Cornell Law School’s Legal Information Institute
- Amortization Calculator — Calculator.net
- Capitalization of Interest in Connection with Loan Workouts and Modifications, 12 CFR Part 741 (2020) — National Credit Union Administration
- Helpful background articles from Experian, Merriam Webster, and Thomson Reuters’ FindLaw, and from additional legal information and finance sites — Various
- Options to Stay in Your Home Overview & Payment Deferral — Fannie Mae’s Know Your Options
- Renewing your mortgage — Government of Canada
- Topic No. 431 Canceled Debt – Is It Taxable or Not? — Internal Revenue Service
- UPDATE 2-Downey sees Q3 non-performing loans at $99 mln — Reuters
- US GAAP: Generally Accepted Accounting Principles — CFA Institute
In addition to these external sources, readers may find multiple links to useful SuperMoney pages in the article above.