The NPV Test

The NPV test should only come up in one specific situation concerning your foreclosure so this post will only discuss the test as it relates to that situation. As I explained in other posts, if you earning a living that is reasonable in relation to your mortgage and you live in your home you will likely qualify for a HAMP trial modification. Once you get through the trial modification you will be reviewed for a permanent modification. If you are rejected for the permanent modification there is a great chance the reason will be that the NPV test failed. There are two ways to explain the NPV test. First I'll give you the short answer and I'll follow it up with the long, detailed answer.

What is the NPV Test? (Short Answer)

It is within the bank's power to determine which is more profitable: (1) Foreclosing on your home, winning the bid at an auction and selling your house to someone else OR (2) Modifying your loan under HAMP guidelines. If the bank determines that they will turn a higher profit through option 1 then through option 2 then they are allowed to deny your modification because the NPV of option 1 is great than the NPV of option 2.

What is the NPV Test? (Long, Detailed Answer)

When determining the Net Present Value of anything (not just your home and your foreclosure) numerous factors need to be considered. Imagine I told you I could give you $100,000 right now or $120,000 next year. You would need to determine which was more valuable to you right now and go with that choice. If you took the cash today you could invest it and at the very least earn interest on the money. You could also pay off student loan debt or your mortgage. I could also die in the next year in which case you may need to hire a lawyer to go after my estate for the money. Therefore it is very possible that the $100,000 makes more sense and its Net Present Value is higher than the $120,000 in a year.

There is convincing evidence to suggest that the $120,000 has a higher NPV. Interest rates are low right now so putting it in the bank wouldn't earn $20,000 worth of interest in a year. You may not have the desire to start your own business with the money. You might now have student loan debt or a mortgage to pay off. So maybe the Net Present Value of the $120,000 is greater. Clearly to make these determinations take time and a careful evaluation of the situation. The bank's determination is no different.

The bank will first evaluation the value of foreclosing on the property. They will need to wait another 6 months - a year to go through the foreclosure, during which time they will take in no money on the property. They will have legal fees and eventually broker fees in marketing the place. During the time they own the property they will pay property taxes, homeowners' insurance and be responsible for repairs. They need to have staff members monitor the property and the foreclosure. The bank will need to determine how much the foreclosure is worth. The most basic way to determine that is by predicting how much the property will sell for and how much the bank will spend to get to that point.

The bank will then need to determine the value of the modification. Remember everyone wants their money as soon as possible. A 30-40 year modification certainly delays the time they will collect their money. Each payment over the time period of the loan will be decreased to determine it's Present Value. All of those payments will then be added together and the bank will determine the Net Present Value of the entire mortgage. The bank will then add the incentive payments that the government provides with a HAMP modification and will compare this number to the Net Present Value of the foreclosure. If the NPV of the foreclosure is higher the bank will reject the HAMP Permanent Modification. If the NPV of the HAMP Permanent Modification is higher the bank will send you an offer and if you sign it the foreclosure will end.

How Do I Know If My Modification is At Risk of Failing the NPV Test?

Keep in mind that I am about to make generalizations. Every property is different and if you are concerning about these issues I would consult an expert on your specific situation.

If a property is "underwater" such that the mortgage is worth $500,000 and the property is worth $100,000 it is extremely unlikely that the homeowner's HAMP modification will fail due to the NPV test. If that property is foreclosed on and sold the bank can make a maximum of $100,000 if it has no legal fees or broker fees, pays no property taxes or homeowners insurance and makes no repairs. Once all of those fees are taken into account the bank is probably only collecting around half of that figure. In addition, it will need to wait months to collect. Therefore the NPV of the $500,000 mortgage, even if the interest rates are down to 2% and it is extended 40 years and a third of the principal is pushed to the back end, should always be higher than the NPV of foreclosing. The bank doesn't want your upside down house. They'd rather you pay off the mortgage at a different rate.

If the property is not "underwater" such that the mortgage is worth $250,000 and the property can be sold for $500,000 there is a great possibility that the NPV test will fail for the HAMP modification. In this situation if the bank forecloses and the property is sold at auction the bank will be able to collect its full mortgage amount at the auction. If they purchase it at auction and sell it a third party they will incur broker fees and all of the other fees listed above but they will get the substantial portion of their mortgage within one year as opposed to waiting 30-40 years to be paid in full. This does not mean that you have no options, it just means that your situation is slightly more difficult. Then again if you're having trouble paying your mortgage but you can sell your house for a quarter of a million dollar profit you're in a substantially better position than the homeowner who passes the NPV test because their property is $400,000 underwater.