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What are the best practices for applying the waterfall method in conventional loan modifications?

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If you are a servicer of conventional loans, you may have to deal with borrowers who are struggling to make their monthly payments due to financial hardship. One of the options you can offer them is a loan modification, which is a permanent change in the terms of the loan to make it more affordable and sustainable. But how do you determine the best way to modify a loan and avoid foreclosure? One of the methods you can use is the waterfall method, which is a standardized process of applying different modification steps in a specific order until the borrower's payment is reduced to a target ratio. In this article, we will explain what the waterfall method is, how it works, and what are the best practices for applying it in conventional loan modifications.

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1 What is the waterfall method?

The waterfall method is a common approach for modifying loans that are insured or guaranteed by the federal government, such as FHA, VA, or USDA loans. It is also used for some conventional loans that are owned or securitized by Fannie Mae or Freddie Mac, the two government-sponsored enterprises (GSEs) that buy and sell mortgages in the secondary market. The waterfall method is based on the principle that the servicer should try the least costly and least invasive modification step first, and then move on to the next step if the previous one does not achieve the desired payment reduction. The steps are arranged in a hierarchy or a waterfall, and each step has its own eligibility criteria and guidelines.

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Jenifer O'Looney

Scrum Master, Agile, Lean Champion, Analyzes data, financials records,businesses, customers, quality and technology. Experienced with new client implementations.
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All are very guideline driven and can change so relying on past knowledge is not wise. Check guidelines always! Keep in mind the persons financial situation can be liquid so consistent communication is the best approach.

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2 How does the waterfall method work?

The waterfall method works by applying different modification steps in a specific order until the borrower's monthly payment is reduced to a target ratio, typically 31% of their gross monthly income. This target ratio is also known as the front-end debt-to-income ratio (DTI), which measures how much of the borrower's income goes toward housing expenses. The modification steps involve capitalization, which adds unpaid principal, interest, fees, and escrow advances to the unpaid principal balance; interest rate reduction, which lowers the interest rate of the loan; term extension, which extends the maturity date of the loan; principal forbearance, which defers a portion of the unpaid principal balance; and principal forgiveness, which forgives a portion of the unpaid principal balance. Each step helps reduce the borrower’s monthly payment and overall debt, but principal forgiveness is rarely used due to potential losses for investors or tax implications for borrowers.

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3 What are the best practices for applying the waterfall method?

To ensure compliance, efficiency, and effectiveness when applying the waterfall method in conventional loan modifications, it is important to follow some best practices. These include evaluating the borrower's eligibility and hardship, documenting and communicating the modification process, following the GSEs or investor guidelines, and monitoring and reporting the modification performance. When evaluating eligibility, you should verify that the borrower meets criteria such as having a documented financial hardship and a sufficient and stable income. Communication should be clear and timely with the borrower throughout the process. You should also comply with any applicable laws and regulations. When monitoring and reporting, track the borrower's payment history, delinquency status, default risk, redefault rate, as well as the impact of the modification on the borrower's financial situation, investor's return, and overall loss mitigation goals.

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4 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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What are the best practices for applying the waterfall method in conventional loan modifications?

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1 What is the waterfall method?

2 How does the waterfall method work?

3 What are the best practices for applying the waterfall method?

4 Here’s what else to consider

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