Mortgage Modifications: When to Say Yes or No

March 11, 2012 — -- You read the headline right. As shocking as it may sound, sometimes it may in fact make sense to say no to a mortgage modification, even when your house in underwater.

As you may have heard, some of the nation's biggest lenders will be offering loan modifications to their customers, and some of those deals will include reducing the amount the borrower owes, a.k.a. "principal reductions." It's part of a multi-state settlement struck with some of the nation's largest lenders, including Ally Financial, Bank of America, Citigroup, JPMorgan Chase, Citigroup and Wells Fargo. (It has not been finalized.)

While some of those principal reductions will be too small to put homeowners above water, the Huffington Post reports that Bank of America will be offering to write down the loans of more than 200,000 underwater homeowners to market value.

Sounds like a good deal? Not so fast. There are times when a loan modification may make things worse.

If you have a second mortgage and your first mortgage is entirely underwater, then your second mortgage is essentially unsecured. In many cases, these second mortgages can be "stripped," or wiped out, in bankruptcy. But if the lender reduces the balance owed on a first mortgage, then the second mortgage may no longer qualify for this relief. Connecticut bankruptcy attorney Eugene Melchionne explains:

…if there is even a penny of value in the home that would go to a second mortgage when the property was sold, the loan cannot be valued as unsecured. That means it must be paid during the Chapter 13 case and it also survives the Chapter 13 as a lien on the property until it's paid off. (Source: Bankruptcy Law Network)

To illustrate, suppose you have a first mortgage of $150,000 with Lender A and a second mortgage for $50,000 with Lender B. You owe a total of $200,000, but your home is worth only $125,000. Let's say Lender A writes down your balance to $124,500. Now your first loan is no longer underwater. However, your second loan still puts you underwater to the tune of $45,500.