Why lenders might forgive your debt

By Liz Pulliam Weston

People who overdosed on debt in recent years learned the paradox of easy credit: While lenders were willing to let you borrow copious amounts, they weren't particularly interested in helping you work out a solution if you fell behind on repayment.

Lenders often found it easier and cheaper to write off delinquent accounts as bad debt than work with you on a repayment plan. After all, they could get a tax break on the loss and then get on with the profitable business of extending credit to the next guy.

Lately, however, lender perspectives have changed. Soaring default rates, a weakened economy and the credit crunch have rewritten the rules.

• Credit card lenders charged off 5.47% of the total amounts owed on cards as bad debt in the second quarter of 2008, according to the Federal Reserve. A year before, the charge-off rate was 3.85%.

• Consumer bankruptcy filings in October 2008 topped 100,000, a 40% increase from a year earlier and the highest level since the federal bankruptcy reform law took effect in October 2005, according to the American Bankruptcy Institute.

• At the end of 2008, more than 2.5 million homeowners were more than 60 days late on their mortgage payments, and that number climed to 2.9 million in January, according to the Hope Now alliance of lenders and credit counselors. One in six homeowners owes more on a home than it's worth.

• As home prices have plummeted, foreclosures in 2008 represented a loss of 44% of the original loan amount, up from 29% the previous year, according to data from LPS Applied Analytics.

That's why lenders are now looking for ways to keep people paying their bills, even if it means forgiving some of their debt. Now the paradox is that in order to qualify, you must be struggling, but not so much that a change in terms wouldn't help you.

How the new programs work

The most sweeping new program was announced Nov. 11. Freddie Mac and Fannie Mae, the government agencies that guarantee 31 million U.S. mortgages, will begin paying the mortgage service companies that maintain the loans $800 for every loan they modify. Borrowers would get help in several ways: Interest rates would be reduced so that borrowers would not pay more than 38% of their gross income on housing expenses. Another option is for loans to be extended from 30 years to 40 years, and for some of the principal amount to be deferred interest-free. (You can find more details here.)

• Problems with debt? Ask a credit counselor . . . free service on MSN Money

The same day, Citigroup announced it would halt foreclosures for borrowers who live in their own homes, have decent incomes and stand a good chance of making lowered mortgage payments. Ultimately, it plans to modify the repayment terms on up to $20 billion in loans.

Late last month, JPMorgan Chase expanded its mortgage modification program to an estimated $70 billion in loans, which could aid as many as 400,000 homeowners. The modifications were to include reducing amounts owed or the loans' interest rates, and replacing so-called "pay option" loans that typically resulted in mortgages growing over time.

Bank of America, meanwhile, has said that starting Dec. 1, it would modify an estimated 400,000 loans held by newly acquired Countrywide Financial as part of an $8.4 billion legal settlement reached with 11 states in early October.

Loan forgiveness is a key part of the Hope for Homeowners program. This is the foreclosure prevention program that Congress created as part of the $700 billion Economic and Housing Recovery Act of 2008. Lenders that want to participate typically must agree to reduce borrowers' principal to 90% of their homes' current value.

But wait, there's more

In late October, a coalition of lenders and consumer advocates asked banking regulators to approve a pilot program that would allow struggling borrowers to pay off, over time, less than they owe -- as much as 40% less. Under current rules, any repayment plan has to be for the full amount owed.

Though the Office of the Comptroller of the Currency rejected the first draft over how banks would book the resulting losses, backers of the plan say they're committed to finding a remedy for overtaxed borrowers that's short of bankruptcy -- which would likely mean the banks see no repayment at all.

In the first proposal, a joint project of the Financial Services Roundtable and the Consumer Federation of America, applicants would have been evaluated by certified credit counselors; those who couldn't pay off their debt under a regular debt management program would have been placed in one of four repayment plans that would reduce their principal by 10%, 20%, 30% or 40%. Only consumers closest to bankruptcy could have qualified for the biggest reduction.

Travis Plunkett of the Consumer Federation of America said his group would continue to lobby regulators "to do everything they can, within bounds of the safety and soundness of the financial system, to help consumers," but that ultimately consumer advocates may have to turn to lawmakers for help.

"It may be Congress that has to step in, and I think there's a lot of interest there" in doing so, Plunkett said. "We've got a train wreck coming."

Continued: Student loans and car debt

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