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You may be able to convince your bank to reduce mortgage principal. At the time of this writing, some of the largest banks in the United States participate in the federal government's Making Home Affordable program. One major part of MHA is the Principal Reduction Alternative, in which the lender cancels part of a mortgage balance. To qualify for PRA, you must have a home worth less than your mortgage, have a mortgage that costs more than 31 percent of your pretax income and a mortgage not guaranteed or owned by Fannie Mae or Freddie Mac. You may qualify for other debt cancellation programs if you do not meet PRA standards.
Before the Making Home Affordable program, banks sometimes agreed to reduce principal, but these situations were rare. Instead, when a homeowner could not afford his home, the lender foreclosed on the property or listened to other offers, such as a short sale or deed-in-lieu of a foreclosure. In a short sale, the debtor sells the home for whatever he can get on the open market. If the debtor lives in a nonrecourse state, the lender approves the sale and cancels any portion of the mortgage the sale does not cover. Under a deed-in-lieu plan,
you give the deed to the bank and it cancels the loan. Both situations are undesirable, because they result in you losing your home.
Talk to Your Lender
You never know what your bank might offer or accept until you talk about it. Foreclosure is the worst-case scenario for both parties, so the bank probably will agree to some sort of loan modification if you cannot pay your mortgage, especially when you miss some payments and have a hardship, such as unemployment. At the very least, the bank might lower your interest rate or refinance your loan to reduce your monthly payment.
Congress reduced the strain of canceled debt income in 2007 with the Mortgage Forgiveness Debt Relief Act. If your lender cancels any part up your mortgage -- up to $1 million -- you do not pay tax as you would on any other forgiven debt as long as the cancellation occurs between 2007 and 2012. However, you still report the forgiven debt to the IRS on Form 982. Also, consider whether you can pay a mortgage even after the lender cancels part of the loan. Delaying a foreclosure is just a temporary solution for the larger problem of not making enough money or owning a home you cannot afford.