There has been a lot of discussion in the news lately about forbearance agreements, but what are they exactly? How do you implement them as a note investor? In this episode Dan Deppen covers what forbearance agreements are and what different types of it exist. He deep dives on the structure he uses to increase the chance that the borrower follows through and some tricks to maximize your ROI. He wraps up with some real world examples. Join in as Dan teaches us how to make the most of this new force in the loan space.
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Designing Win-Win Forbearance Agreements
How To Design Forbearance Agreements To Maximize Chance Of Borrower Success And Profit
In this episode, I’m going to be talking about forbearance agreements. Forbearance agreements are something that’s been in the press with COVID and everything else going on. A lot of the banks have been issuing these and there’s a lot of discussion about them in various parts of the media, but there’s also a lot of confusion around what exactly they are and how they apply. What I want to try to do is clear up some of that confusion, but then also talk about the way that I like to implement these and the structure that I like to use that I’ve had a lot of success with.
We’ll start by talking about what a forbearance agreement is or what forbearance is. If we look at the dictionary definition of it, it’s a temporary postponement of the mortgage payments. The lender is granting some relief to a borrower who has an inability to make payments. It’s an agreement you’re coming up with in lieu of proceeding with a foreclosure overall. The reason the lender is going to do this is because the lender thinks they’re going to get a better outcome ultimately than powering ahead and going through foreclosure.
For borrowers who may have hit some a hiccup or a problem where they can’t make payments, that’s an agreement that lets them eventually get back on track without facing foreclosure but there are a million ways that these things can be formed. If you look at some of the ways that lenders will set these up and this is where a lot of the confusion in some of the news stories happens because people make different assumptions. It’s generally not just forgiving and writing off a certain number of payments, although it could be in some cases. Sometimes it could be the lenders going to defer some number of payments to the end of the loan and then create a balloon payment at the end.
The other one that I’ve heard of is sometimes lenders are deferring maybe 4 or 6 payments, but then there’s a balloon due at the end of that period. From some of the articles that I’ve been reading, some of the lenders have loans they’ll say they’re letting the borrower go six months without making a payment, but then they’re expecting those six payments at the end of the six months. I’m honestly not quite sure how that’s supposed to work. That seems like a recipe for problems for everybody. There are a million other forms of this.
Before I get into my structure, which is a little different than those, I want to reiterate that if you’re a lender and you’re going to grant a forbearance agreement, remember what your number one goal is. That’s that you’re looking for a better outcome for you than you would get by going through foreclosure. I’ve talked about this on several other episodes. If you do take a loan through foreclosure, take it back as an REO and sell it, your range of outcomes in terms of returns are all over the map. Usually, when you get the properties back, they’re not in great shape.
For me, I go out of my way to try to prevent foreclosure because it’s expensive. It costs several thousand dollars. It can take a long time, especially depending on the state. In 2020, with a lot of the courts shut down for a while due to COVID, even now the courts that are back open, being backlogged and I’m having a hard time getting hearings scheduled. Foreclosure can be a long process and it’s generally financially never remotely as good an outcome as getting the loan reperforming. My goal with these is to get into a situation where we get the loan back on track. I can turn it into a performing loan and then resell it later on. I’m going out of my way to try to prevent foreclosure. It doesn’t always work.
Remember, before we dive too deep into this too, that you have counterparty on the other side. The borrower gets a say in all this as well. You can create the most optimized, elaborate forbearance plan that you’ve analyzed to death but the borrower may or may not cooperate with it. There’s a lot more art than science when you come down to it. The borrower is always getting a vote. Some of the big things for the borrower that could change your plans are, number one, do they even want to stay in the home?
If the borrower’s ready to move on for whatever reason, it could be that they’re just ready to move or they’re sick of the whole deal. It could be that there’s a big crack in the foundation and they don’t want to live there anymore. The roof is leaking or the furnace is dead and we’re getting into winter or whatever. If they don’t want to stay there, you’re not going to be able to get to some agreement that gets them paying again. Another thing is, do they even have the ability to make the payments that you would like them to make? I’ve got one loan given the borrower’s situation and the value of the house and the size of the loan.
There’s no scope to come up with an agreement that makes sense for me, as the lender that the borrower would be able to perform on. Another thing to consider is why they were behind on the loan in the first place. Oftentimes, borrowers fall behind for reasons that are temporary and they can recover from. For example, if the borrower got hit maybe with some medical bills, it set them back, they stopped paying the mortgage, they got behind. Maybe the previous lender didn’t talk to them or work with them. They weren’t sure what to do and so they didn’t want to throw money down the drain and then stopped. That can be a situation where once the borrower gets through their medical situation, they can get back on track.
Divorce is another big one that causes these to go red and stop paying. Sometimes it’s a job loss or they’re out of work for a number of months, but then they get working again. Those situations where the reason for falling behind was temporary mean there’s going to be a little higher probability that you can work something out and get something on track. It’s more likely then that they want to stay in the home, but they hit some hiccup. You also have to look at what their history has been and track record. They’re definitely not the majority, but you do get some borrowers who don’t like paying their bills. They’ve fallen behind because maybe the previous lender didn’t keep on top of things and either follow up with them or foreclose or do whatever they had to do and they got used to not paying and nobody doing much. That borrower is going to be more likely to not follow through in a forbearance plan or get through a forbearance plan and have problems after that.
Some other things to consider too was getting into with these plans, I like to have some good faith downpayment. Do they even have money to do that? Sometimes they don’t. Another one is, are the borrowers even responsive? Some borrowers you cannot get a hold of no matter what. Although I have had some borrowers where I couldn’t get ahold of them to work something out. We could never talk. I started the legal process and I still couldn’t get ahold of them. They get right to the end where they’re about to lose the house, they then come online and then all of a sudden, they cough up a lot of money to reinstate. It’s weird. If you’re trying to reach an agreement with the borrower and the borrower won’t even come online and talk, it’s a little bit hard to get an agreement in place. Sometimes despite your best efforts, you’re not going to be able to do anything. I want to kind of explain that. Now, I get into the structure of how I like to set these up.
Trial Payment Plan
My ideal structure is a forbearance agreement/trial payment plan. There are three components to this. The first one is that I want to collect some good faith down payment from the borrower. With step number one, which is a good faith down payment, this is what gives the borrowers skin in the game. What you don’t want to have happen is have a borrower make an agreement as almost as a stalling tactic and then never follow through. That’s why I like to start off as large as a possible with good faith down payment so it gives them skin in the game.
They’ve got an incentive to follow through because they’re going to lose that payment if they don’t. From a return perspective, it’s nice if you get a non-performing loan to get this cash infusion. The second part of it are the trial payments. I usually set this up with 6 to 12. The purpose of the trial payment period is the good faith down payment comes first. They’re going to then make 6 to 12 trial payments. This is where the borrower demonstrates that they have the ability to make regular payments. What we’re leading to is the loan mod. We want to make sure they have some ability to make payments on a regular basis, not just make a one-time payment. The third step is to modify the loan and the way that you modify the loan, there are a lot of variables you can’t control.
There are a lot of different ways you can do that, but once you get to the point where you have the loan mod in place, now the borrower has a current loan. They’re at no more risk of foreclosure, assuming they don’t default again. As the lender, you’ve now got a much more valuable loan because now you’ve got a performing loan versus your non-performing loan. You can sell this at a much higher percentage of the unpaid balance than what you bought it for. As we’ll get into it, there are some little tricks you can do to increase the amount of the unpaid balance as you do this.
I’m going to break down these three components and go a little bit more in-depth because it’s one thing to say what the three are, but then the next question is what do I ask for, which of these numbers be? Starting with the good faith down payment, the higher amount that you can get, the better. Most of mine are in the $1,000 to $2,000 range. I’ve seen them as high as $5,000. That’s awesome if you can get it. It’s better from the standpoint that you’re getting this cash early. It helps you return.
Remember, the main thing we’re trying to do here is given the borrower skin in the game so that they’ve got this incentive to follow through and not just peter out and not follow through in their forbearance agreement where you have to go back and foreclose. Ideally, if you’re looking for rules of thumb, a lot of this will depend on the size of the loan and the payment. I like to see this be about three times the size of the regular payment and 5 or 6 is better. Let’s say it’s a contract for deed with a $300 and $350 P&I payment. Getting $1,000 is not bad. Although a lot of times I’ve gotten $1,500 or $2,000, all those.
Most times, anything that gets a loan back up and performing is better than going through a foreclosure. Click To TweetIf you go below 3X, it’s a little dicey, although I’ve had borrowers make no good faith downpayment and follow through. It’s a little hard to say and a lot of this comes down to borrower behavior. You’re never sure what they’re going to do. You’re just trying to stack the deck in your favor. At the end of the day, when it comes to the good faith down payment or forbearance agreements in general, sometimes it takes what you can get. Our goal here is to get an outcome that’s better than a foreclosure. For me, I might try a forbearance agreement without a good faith downpayment even though I know it’s flaky and it may not work. It can be worth giving it a shot to work. If it does, now you get the performing loan. The risk is you might be delaying when you start your foreclosure. Sometimes too borrowers have good stories on why they don’t have any money to put the good faith downpayment, but that they can begin making regular payments.
Now, with the trial payments. The purpose of the trial payments is for the borrower to demonstrate that they can pay on a regular basis. I’ve generally set these up as 6 to 12. When I started doing this a few years ago, I mostly did twelve. I’ve increasingly been doing six. The trade-off there. From the standpoint of having more trial payments, the more trial payments the borrower can make, they’re getting more skin in the game. As they go along, they’re demonstrating a better track record. When you ultimately modify the loan, there’s a little better probability they’re going to follow through. If you made it, let’s say a real short couple of months, they might be able to cough up a good faith down payment, a couple of other payments, but then they’re not going to stay on track necessarily.
However, the downside of increasing the number of trial payments as a lender is some of this depends on your timeline. If this is a note that you own and let’s say a self-directed IRA and you plan on holding this after it’s performing, then it might err on the side or more payments. I’m not under any time constraints to try to get to an exit. If you’ve taken outside money and let’s say you’re doing a joint venture or something like that, then your joint venture partner has an expectation that they’re going to get their money back within 18 to 24 months. That’s a little bit more of an argument to get the trial payment shorter to get to the mod faster so you can get the new loan seasoned, then resell and exit. A lot of times, these things come down to more art than science.
Now with modifying a loan. This is where it gets weird. I’ve got an elaborate spreadsheet that I built to look at all the parameters so I can tweak some knobs and try to optimize these as best I can. It’s not a spreadsheet that I’ll share, but I’ll explain the thought process behind it so that you can put these together yourself. When you’re modifying a loan, the one thing you could do is you could create a brand new loan. Whatever you had before, it was a contract for deed or mortgage, you could have the borrower cancel that one and you could create a new one for scratch. It could be a true modification where you’re modifying some of the terms of the loan. If it’s a contract for deed, one of my favorite plays is to agree to cancel the contract for deed, create a new mortgage and convert it from a contract for deed to a traditional mortgage. This is nice from the borrower’s standpoint because now they’re on the title.
They’re not just doing a land contract, which is a subject for another day. To me, it’s a glorified rent to own thing. I know lease options are different, but if you can create a traditional mortgage for them, then they’re the ones that are entitled. They have a sense of ownership. They have more rights to it. It’s a better situation for the borrower. As the lender, since a lot of note investors are afraid to buy CFDs for various reasons, all things being equal, you can sell a performing mortgage for more than a performing contract for deed. That’s one of the ways you can increase your value and your salability as a loan if that is your intention to turn around and resell it. If this is something you’re holding in an IRA, maybe you plan to hold onto it, then you may not care about that as much.
The other benefit to doing that too is if you can go from a CFD to a mortgage, you’re getting yourself off the title. That’s nice too because if the borrower starts racking up code violations or utility bills or some of these things where the city and the County come calling to you because you’re on the deeds. Getting off of that can save you some headaches as well. The other big question is what to do with the remaining arrearages. If this loan was non-performing, there’s typically accrued interest perhaps charges for taxes and insurance that lenders have paid overtime. Sometimes when people modify these, they tack that onto the back of the loan as deferred principle. That’s one option. I’m not a huge fan of that option.
You can also forgive some of the arrearages as part of the deal and that can be an additional incentive to get the borrower to follow through. There are a lot of knobs you can turn a lot of options and how you create this loan. Talk a little bit about how you can structure these to try to optimize your ultimate return on the loan, which is what your goal is. When we structure the new loan, here’s the ideal template that I try to use. Number one is those arrearages, accrued interest, lender advances and late fees, etc., as part of the agreement that I’ve made upfront is I like to roll those into the unpaid balance of the loan.
As you may or may not know by now, when you’re pricing a loan, especially if it’s a non-performing loan, there will be two values for the balance. There’s the unpaid balance, which is the actual balance and then there’s a payoff amount. The payoff amount involves all these other charges, but when you’re pricing, you always want to price based off of the unpaid balance because depending on how well the previous lender and service are kept records, all of that payoff amount may or may not be collectible.
When we’re modifying our new loan, if we take those arrearages and roll them into the unpaid balance, now when we go to resell the loan, the buyer is considering that entire value instead of just the portion that was the UPB previously. That’s a great way to pump up your return, especially with some of these loans that have a lot of arrearages in them. At the same time, if we’re going to increase the balance of the loan, you don’t want to have to increase the P&I payment. You have a borrower who at some point was not performing on the old payment. You don’t want to raise it a lot because if you do that, how do you expect them to perform on that.
I try to keep the P&I of the new loan around as close to the P&I of the old loan as I can. I tend to do that by stretching the loan term out. From the borrower’s perspective, even though the UPB just grew, these are charges that they’re still on the hook for, but you’ve rolled that into the new loan without increasing their payment. You just stretched the term a little bit. An additional care for the borrower to go along with this could be, if it’s a contract for deed, converting it to a traditional mortgage and getting on the title. When you can roll those arrearages into the UPB loan, you can significantly increase its value. It’s one of my favorite things to do to pump up the ROI on my deals.
Drafting The Agreement
The next thing is let’s say you’ve looked at your loan. You looked at how far the borrower’s behind, what the arrearages were and you’ve come up with your perfect plan for your forbearance agreement. That includes a good faith down payment of X amount, X number of trial payments and then some modification to a new set of loan terms. Now, you’ve got to have that discussion with the borrower to see if they’re interested and see if they will go along with that or have that negotiation. My recommendation for folks, especially when they’re newer, unless you’ve had the right training, is to have your servicer help you with this. There were some vendors I used to use for this previously that were no longer in business. The best option is to draft your agreement, have a conversation with your asset manager at your servicer and have them approach the borrower. Be clear throughout the whole process, what all of your intentions are with this. Your goal is for the borrower to be back on track, it might be to have them on title versus not be on title.
Your intentions are, if you can’t get an agreement in place that you are going to follow through on the foreclosure. That’s a whole another topic for another day is if you’re going to follow through in the foreclosure or not. A lot of lenders will buy a non-performing loan. They will try and work out these agreements. If they can’t resolve the loan, that’s not my model. What I like to do is take them all to the mat and there are some reasons for that. That’s another subject we’ll get into another time. I don’t want to detour too much here. You do want to make it plain to the borrower as well that you’re offering a good deal and an opportunity to get back on track. The alternative is you’re going to follow through on this foreclosure.
Getting the agreement drafted. Sometimes servicers can write these up for you but if not, have an attorney write it up. Brian Gallagher is good for a lot of these depending on what state you’re in. I like to use Franco Barile for a lot of these as well, particularly Michigan, Indiana, Ohio and Illinois. Once you have an agreement in place, you can use it as a template but have someone draft this for you. I’ve got one that I like and as things have evolved too and sometimes it’s rare. Sometimes I’ve had borrowers who have had attorneys to help represent them in this and they’ve come back with different comments. My agreement has evolved over time a little bit and it gets better and better like my spreadsheet. That’s something I don’t share. Talk to your servicer or talk to your attorney and see what you need to do to get this drafted. If you give them the high-level terms of what you’re trying to do, they can help you put this together.
What happens after, let’s say you’ve written your forbearance agreement, you reached an agreement with the borrower or maybe the borrower accepted what you proposed or maybe they pushed back and ended up with something a little different than what you originally wanted, what happens now? The big thing is you want to monitor it closely. If the borrower starts to not follow through or they miss a date for a good faith down payment or they’re a couple of days late on the first payment, you want to intervene quickly if they get off track. I haven’t gone back in and looked at my data on the percentage of the time where the borrower doesn’t follow through. A lot of these do fail. These are definitely not a foolproof thing. It’s like everything in the loan business. The proof is in the pudding.
My philosophy is whether you’re talking about forbearance agreement or a sale of an REO or a sale of a note or purchase of a note, nothing’s ever final until the money hits the bank. Just having an agreement does not mean you’re there. You get to see how well they follow through. A lot of these do fail. In some cases, what I do is follow up directly myself through either a letter or a phone call. I would only do that if you have the experience and the training and you understand the rules around doing that or have your servicer do that for you. Early intervention is the key. Don’t let these things go.
Sometimes they fail on the first one and then I’ve tried again and had to go. I have one where we’re on the third forbearance agreement. This time it seems to be sticking. That’s rare. I don’t necessarily recommend giving them three tries, but in this case, it’s going to be a better outcome for me than if I had gone through with the foreclosure. Remember too if you’ve started legal, sometimes what happens in these is maybe you can’t get ahold of the borrower. You send a demand letter and you start the legal process.
Whether you're talking about forbearance, a sale of an REO or a sale of a note, nothing's ever final until the money hits the bank. Click To TweetMaybe it’s the very beginning of the legal process. You send a demand letter. Sometimes, I’ve had borrowers want to do forbearance agreements once we get far down the legal process. If you’re in that case, you’re going to want a much harder good faith down payment. You want to get paid back for your legal expenses. Do remember, if you started legal and then you put an agreement in place and you accept payment, if the borrower fails after that, you need to start legal all over again. Keep that in mind, stay in real close communication with your attorneys and your loan servicers as well.
Sometimes what happens is let’s say you’ve incurred a significant amount of legal expenses. To justify putting a forbearance agreement in place, you need a large good faith down payment. Let’s call it a $4,000 good faith down payment. You would want to give your servicer instructions that say, “Expect a $4,000 payment and please accept it. I understand this cancels legal. However, do not accept anything less.” What could happen in that situation is the borrower might send in $1,000 or a couple $100 or send in a regular payment. You don’t want to accept that and have that mess up your legal process if that’s what you need to do.
When we’re designing this agreement, talk about some of the goals a little bit and some of the strategy behind how we’re putting these together. For the good faith downpayment, it is pretty straightforward. You’re trying to maximize. You’re trying to get what you can because it’s better for you. You take smaller when you don’t have another choice. The big one is maximizing the value of the new loan or the modified loan that you’ve created. Rolling as many arrearages as you can into the unpaid balance is helpful.
I like to convert to a mortgage if it’s a contract for deed and if the borrower is agreeable and if they can meet the Dodd-Frank rules, if you can get through the underwriting, then that’s good. You can’t always do it. You may have a situation where you want to convert it to a mortgage. The borrower would like to convert it to a mortgage, but their credit’s terrible and you can’t create a compliant mortgage. The other thing you can do to try to maximize the value of your loan is to minimize the term. Ten years is ideal. I’ve had discussions with First National Acceptance who will buy performing loans.
They said that their ideal scenario for a loan was what they called 10-10-10, so 10% down payment, 10% interest rate and 10-year term. In this case of a modification, you might’ve had a good faith down payment as part of your forbearance agreement, but then when you do create the new loan at the back end, there’s not going to be another down payment there. That aspect of the 10-10-10 doesn’t apply. I’m not a huge fan of the 10% interest rate. I know some jurisdictions. I’m usually sending it may be around 8%, sometimes less. It depends.
The ten-year term is nice. If you set it up as a ten-year term, your P&I is going to be higher. All things being equal, the loan with a ten-year term is going to be more valuable than the loan with a 30-year term. That’s a topic for another day. I don’t have time to deep dive into the math behind why that is the case right here. Remember too, as designing this agreement, we’re always trying to maximize the probability that the borrower is going to follow through. That trumps trying to maximize your potential return. If you get the borrower to re-perform, if you can get it to a performing loan, you’re going to be doing great almost all the time.
If you can optimize it from there, you can increase the UPB, you get the loan terms right. That’s the icing on the cake. You want to do that where you can, but the main thing is maximizing the probability that the borrower’s going to follow through. That can be trying to get the higher, good faith down payment. Sometimes forgiving arrearages can be part of that. Let’s say the borrower has a lot of arrearages. Let’s say it’s $40,000 UPB and then $10,000 of arrearages. You might be able to work something out or say, “If you follow through on this agreement, I’m going to forgive a percentage of the arrearages.”
In an effort to get a higher, good faith down payment you may say, “A minimum, good faith down payment of $1,000 and I’ll match that in forgiveness of arrearages dollar for dollar. If you want to make a higher, good faith down payment than that, I’ll match every dollar you put in dollar for dollar.” You can get your incentives aligned with the borrower that way. As I said, this is a lot more art than science when you get down to it. You’re always going to be limited by what the borrower is willing to agree with and what the borrower’s going to follow through on as well.
Case Studies
I’m going to show a couple of quick mini case studies on these. As I started doing more and more of these and learning about them and understanding the math behind them, I think I’m a lot better at optimizing them now than what it was a couple of years ago. I’ve done some of these where I put them together and then we get to the loan mod and I was kicking myself because I saw things later that I could have done differently that would have increased the value of a loan.
This case study, number one, I’m not going to get into the property’s unit addresses because that’s not really what matters. I’m going to talk about a lot of numbers, but I’ll try to keep it simple and clear for those that are reading. This was a note I paid $17,000 for and had an unpaid balance of $43,271. It had arrearages of about $5,800. The reason for the default was a divorce. That’s not a good thing, but from the lender perspective, that’s a good reason as that’s something people tend to recover from. In this case, we’ve got a good faith down payment of $1,000 from the borrower and then they make six trial payments of $621.97.
The borrower completed the plan. We rolled the arrearages into the loan. By the time you account for collecting the good faith down payment, the trial payments that came in, our new unpaid balance ended up being right about $46,000. We increased the balance from about $46,000, from a little over $43,000 and we collected $1,000 upfront and then six payments of $621. It’s about $4,600, $4,700 altogether and we got a loan with a bigger UPB that’s performing. The borrower doesn’t always cooperate. Right after we modified the loan, the borrower misses two payments right off the bat, which was brutal because I had already modified the loan.
I was able to get the borrower caught back up but that did decrease the value that I was able to resell the loan for. I was able to sell the loan for $26,800, which is not bad. It could have been a lot higher than that had the borrower followed through directly after we reset the loan. Still, if you look at this, run this for $17,000 and we’re getting out $1,000, good faith down payment, plus six payments of $621 and then sell the loan for $26,800 at the end. The total ROI was about 38%. There was a JV partner on this. They saw a half of that. They saw at 19%. The return, let’s say, a little over a year until we did it. The joint venture partner’s annualized return was 16% and that was after the 50/50 split.
This was not even that ideal scenario. We’ve got a relatively small, good faith down payment and didn’t even resell the loan for nearly as much as I would have liked to. If you start digging into the math on these, you’ll see that when you get this re-performing, your ROI gets good even with 50/50 splits. The second one I’ll show. This wasn’t note that I paid $27,500 for. The UPB was around $45,000 and they had about $6,300 in arrearages. I don’t know what the original reason was for default. This was one where I couldn’t get a good faith down payment out of the borrower and they agreed to six trial payments.
This is against all my rules. It’s dicey, but the way that I viewed this is I may as well take a chance on this. If the borrower follows through, I’m going to do well. If they don’t, I’m going to start the legal process anyways, and worst-case scenario, I add a couple of months to my timeline. It’s not a big deal for a shot at getting it re-performing. In this case, the borrower, who did follow through, completed the plan and then our new unpaid balance ended up being a little over $51,000. We seasoned it for six more months, and sold it for $33,900. As a percentage of UPB is lower than what I would like to see on our re-performing loan, but the interest rate on the underlying loan was on the low side.
That can affect reconsolidation as well. This worked out to a 24% ROI or 12% to the JV partner. This was a relatively fast deal as well. Their annualized return ended up being 15%. That was even after the 50/50 split. The point behind showing you these are some of the ways they can go. Even if you don’t get the perfect deal that you want to get, you’ll still do well if the borrower ends up re-performing on them. That wraps up my formula for forbearance agreements. If you have any questions, please give me a holler and I’ll talk to you next time. Thanks.
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