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LHarveyMadman · 07-05-2009, 11:47 PM

To understand the NPV test, the important thing to realize is that it is test for the bank to determine which option would lead to a better outcome for the bank, not the borrower.

The easiest way to understand this is by setting up two scenarios, to illustrate a positive NPV and a negative NPV test.

For both scenarios, assume that the borrower is in financial hardship and is unable to afford the loan payments and will go into foreclosure without a modification. These are highly simplified - no situation is going to be as basic as these - but I'm laying these out just to provide a very basic illustration.

Scenario #1: The borrower is in a hard-hit area, with loan balance of $500,000 at 7% and a market value of $250,000. If the bank lets the home go into foreclosure, it will lose a lot of money, because it will recover only half of what the borrower owes. If they reduce the borrower's interest rate to 3% and the borrower can afford the loan, then the bank doesn't lose any money and continues to collect interest and principal payments. The NPV test is positive, in favor of modification.

Scenario #2: The borrower lives in an area that has not seen a price decline, and owes $500,000 on a home worth $550,000. The interest rate is 7%, but the borrower can't refinance because he's been late several times in the last couple years. The bank looks at a possible modification with an interest rate of 3% and compares it to what would happen if the home went into foreclosure. Because the home value exceeds the loan balance, the bank stands to recover its entire investment. If the money it stands to collect with a modification is less than what they would recover in foreclosure, then the NPV test is negative, and the bank is under no obligation to modify the loan.

Things get more complicated if there is PMI in place, because even under scenario #1, if the home goes into foreclosure the bank would collect an insurance payment from the mortgage insurance company that would offset part of their loss. This offset would be used in the NPV test.

07-05-2009, 11:47 PM	#15 (permalink)
LHarveyMadman Senior Member Join Date: Oct 2008 Location: California Posts: 554 Nominated 0 Times in 0 Posts TOTW/F/M Award(s): 0	Re: B of A Did'nt sound Promising! To understand the NPV test, the important thing to realize is that it is test for the bank to determine which option would lead to a better outcome for the bank, not the borrower. The easiest way to understand this is by setting up two scenarios, to illustrate a positive NPV and a negative NPV test. For both scenarios, assume that the borrower is in financial hardship and is unable to afford the loan payments and will go into foreclosure without a modification. These are highly simplified - no situation is going to be as basic as these - but I'm laying these out just to provide a very basic illustration. Scenario #1: The borrower is in a hard-hit area, with loan balance of $500,000 at 7% and a market value of $250,000. If the bank lets the home go into foreclosure, it will lose a lot of money, because it will recover only half of what the borrower owes. If they reduce the borrower's interest rate to 3% and the borrower can afford the loan, then the bank doesn't lose any money and continues to collect interest and principal payments. The NPV test is positive, in favor of modification. Scenario #2: The borrower lives in an area that has not seen a price decline, and owes $500,000 on a home worth $550,000. The interest rate is 7%, but the borrower can't refinance because he's been late several times in the last couple years. The bank looks at a possible modification with an interest rate of 3% and compares it to what would happen if the home went into foreclosure. Because the home value exceeds the loan balance, the bank stands to recover its entire investment. If the money it stands to collect with a modification is less than what they would recover in foreclosure, then the NPV test is negative, and the bank is under no obligation to modify the loan. Things get more complicated if there is PMI in place, because even under scenario #1, if the home goes into foreclosure the bank would collect an insurance payment from the mortgage insurance company that would offset part of their loss. This offset would be used in the NPV test.