You and your lender are talking mortgage modification. You have a $300,000 mortgage on a $200,000 house. You're paying 6% because you can't refinance to a better interest rate. What would you rather have the lender do, drop your interest rate to 2% or your balance to $200,000? Most borrowers would take the $200,000 balance. And now, more lenders may be willing to give it to them--especially bad credit lenders that don't sell their loans to investors.

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The most popular modifications with banks are:

1. Taking the missed payments and adding them to the loan's balance.

2. Stretching out the loan's term to 40 years.

3. Reducing the interest rate to as low as 2%.

But these strategies have been less than effective, not only for the borrowers, but for the lenders!

It's All About the Baggage

One big reason is the psychological baggage that comes with paying every month for a property worth less than the balance of the mortgage--sometimes a lot less. By reducing the principal balance to the home’s current value, lenders have a better chance of getting a genuine effort from the homeowner.

And according to the Office of the Comptroller of the Currency, lenders are figuring this out--loan modifications with principal reductions increased from 3.1% in the first quarter of 2009 to 10% in the second quarter of 2009. And the trend continued in the third quarter of 2009--principal reductions rose to 13% of modifications. The OCC also states that loan modifications based on interest rate reductions are ineffective long-term strategies. The agency reported that of the loans modified in the first quarter of 2009 using interest rate reductions, 28% were in default within 90 days, and a whopping 56% were in default in a year!

The Big Booger

Before you ask your lender for a principal reduction, understand that the banks that offer loan principal reductions actually own the mortgage. Loan servicers that don't own the actual mortgage aren't offering reductions. But that's not bad news for you--an interest rate reduction can actually be a better deal for you than a principal reduction.

Run the Numbers

Take that $300,000 loan on the $200,000 property at 6% and run this through a mortgage calculator. Your payment is more than $1,800 if you have had that loan for a couple of years. By offering you a 2% interest rate and a 30-year term, your lender gets $1,109 a month and a total of $399,189 over the life of the loan. Remember also that mortgage modification is voluntary on he part of the lender. By offering you a $100,000 reduction and the same 30-year term, but no change in interest rate, your lender gets $1,199 a month and $431,686 over the life of the loan. So if the lender offers you a 2% rate instead, realize that you may be getting the better deal.