A Breakdown of the Changes in FHA Distressed Loan Mitigation, New Guidelines Impact, and Remediation

Dain Ehring

April , 2025

Current FHA Loss Mitigation Process

The current workflow for the Federal Housing Administration (FHA) loan loss mitigation and workouts is a structured process designed to assist borrowers in financial distress while minimizing losses to the FHA’s Mutual Mortgage Insurance Fund. This workflow, based on policies such as Mortgagee Letter (ML) 2024-02 and earlier COVID-19 frameworks, will be updated with ML 2025-06 (effective February 2, 2026). Here is a high-level overview:

Current Workflow Overview

1. Borrower Hardship Trigger

   The process begins when a borrower shows signs of distress. While early intervention is recommended, servicers identify loans that are 61 days or more overdue.

   
   

2. Initial Assessment and Outreach

   Servicers assess income, employment, and home retention intent to determine eligibility. (Using existing COVID-19 recovery options through April 30, 2025.)

   
   

3. Loss Mitigation "Waterfall" Execution

   Servicers follow a “waterfall” approach:

   
   

   1. Early Intervention: Forbearance (up to 12 months) or repayment plans for missed payments.

   2. Payment Supplement: Starting in 2024, this tool uses partial claims to cure arrears and reduces principal by 25% for three years.

   3. Loan Modification: Adjusts terms (30-40 years) for lower monthly costs, often paired with a partial claim to clear past dues.

   4. Disposition Options: If retention fails, pre-foreclosure sales or deeds-in-lieu provide exits.

   
   

4. The waterfall allows servicers to tailor solutions without rigid borrower contact mandates (e.g., Advance Loan Modification).

   
   

5. Implementation and Monitoring

   Servicers then execute agreements and submit claims to HUD while monitoring compliance, typically over a three-month trial period.

   
   

6. Reporting and Compliance

   Servicers track outcomes and submit data to HUD. Compliance with FHA timelines ensures reimbursement and avoids penalties.

   
   

Upcoming Changes to Workflow

The forthcoming ML 2025-06 (January 2025) shifts this workflow:

• Permanent Structure: COVID-19 options fold into a lasting waterfall, effective February 2026, with refined guardrails.

  
  

• Stricter Rules: One retention option per 18 months, mandatory trial plans, and borrower attestations aim to curb redefaults and abuse.

  
  

• Operational Impact: Servicers face tighter timelines and documentation demands, requiring system upgrades by mid-2025 to stay ahead.

  
  

FHA Loans Are Under Abnormal Pressure Today

The FHA loan portfolio faces increased risk in today’s economic environment, particularly due to the potential for a recession associated with possible tariff battles, which coincides independently with the upcoming changes.

The FHA insures loans for borrowers with lower incomes, limited credit histories, and minimal savings—such as first-time homebuyers or those with median incomes around $60,000 to $70,000. These individuals are already stretched thin: high debt, low reserves, and unstable employment. When economic shocks occur, they are the first to feel the impact.

Inflation is hovering around 2.8% to 3.5%. Morningstar has already lowered its 2025 GDP growth forecast by 0.7 points to approximately 1%, and the odds of a recession are increasing—JPMorgan estimates them at 60%, while Goldman Sachs estimates them at 35%.

Delinquency rates are rising. FHA loans are historically riskier than conventional ones; before the 2008 crisis, serious delinquency exceeded 14%. Today, only 21% of FHA first-time buyers have one month in reserves or more. FHA loans will face increasing pressure if unemployment rises to 4.5%.

If the tariff battle shrinks export markets, industries that employ FHA borrowers will be affected. Construction costs are up, too; steel tariffs alone could push new home prices higher, straining affordability. If consumer confidence falls, spending drops, jobs follow, and FHA defaults spike.

The risk associated with FHA loans has increased. Tariffs amplify economic uncertainty, and FHA borrowers—characterized by low reserves, high debt, and job vulnerability—are the canary in this coal mine. A slowdown could push delinquencies beyond sustainable levels.

We have increased economic pressure on FHA servicing portfolios, which will increase delinquency rates while new loss mitigation requirements are being introduced, changing the way mitigation is handled today.

Quantifying the Servicing Enterprise Risk

If a large FHA loan servicer fails to implement the 2025 loss mitigation changes (Mortgagee Letter 2025-06 and the Payment Supplement program) on time, the monetary risks can be significant.

Potential losses depend on the servicer’s portfolio size, delinquency rates, and operational efficiency. Below is a breakdown:

1. Regulatory Penalties and Enforcement Actions


   The FHA and HUD expect compliance with loss mitigation deadlines (e.g., February 2026 for permanent waterfall changes). If a servicer drags its feet:

   
   

   1. Fines: HUD can impose civil penalties for non-compliance with FHA servicing rules. These can range from thousands to millions, depending on the scale of violations. Systemic failure could lead to seven-figure fines for a large servicer with thousands of loans.

      
      

   2. Reputational Hit: Non-compliance might trigger HUD audits or sanctions, which could spook investors or Ginnie Mae (who securitizes FHA loans), potentially limiting the servicer’s ability to operate in the FHA space. Losing FHA approval would crush revenue streams.

   
   

   1. Buyback Risk: If loans are mismanaged (e.g., improper loss mitigation leading to foreclosure), Ginnie Mae might force the servicer to buy back loans from pools, tying up capital and eating into liquidity.

      
      

2. Increased Defaults and Foreclosure Costs


   Without timely implementation, servicers might not offer borrowers the right relief options (like trial plans or Payment Supplements), pushing more loans toward default or foreclosure:

   
   

   1. Advance Costs: Servicers must cover principal, interest, taxes, and insurance on delinquent loans until resolved. If delays lead to prolonged delinquencies, these advances can balloon— possibly $10,000-$20,000 per loan for a year of missed payments, multiplied across hundreds or thousands of loans.

      
      

   2. Foreclosure Expenses: If borrowers slip into foreclosure due to missed mitigation opportunities, servicers face legal fees, property maintenance, and disposition costs—often $30,000-$50,000 per foreclosed property. Large servicers with high FHA volumes could see millions in losses here.

      
      

   3. Claim Denials: When filing for FHA insurance claims on foreclosed loans, HUD might reject or reduce payouts if the servicer didn’t follow the updated waterfall (e.g., skipping mandatory trial plans). For a $200,000 loan, losing even half the claim is a $100,000 hit—when scaled across a portfolio, it is crippling.

      
      

3. Missed Incentive Payments


   The FHA offers carrots to encourage compliance, like a $1,750 incentive per successful Payment Supplement. If a servicer isn’t set up to process these by the deadlines, they’re leaving money on the table—potentially hundreds of thousands for a large portfolio. These incentives offset operational costs, so missing them tightens margins.

   
   

   1. Operational Overload and Inefficiency

      Late implementation means playing catch-up, which spikes costs:

      
      

   2. System Upgrades: Rushing to update servicing platforms to handle new rules (like tracking 18-month retention limits or trial plans) could mean premium vendor fees or overtime for IT teams—potentially $500,000-$1M for a large servicer’s tech overhaul.

      
      

   3. Staffing Strain: Training or hiring to manage the backlog of cases under new guidelines costs money. A large servicer might need dozens of extra loss mitigation specialists at $60,000-$80,000 per head annually.

      
      

   4. Borrower Disputes: Delays could lead to more borrower complaints or legal challenges, requiring legal teams and settlements. Even one class-action suit could cost millions in fees and payouts.

      
      

4. Liquidity Squeeze


   Large servicers rely on credit lines to fund advances and operations. If non-compliance leads to higher defaults, denied claims, or regulatory restrictions, their cash flow takes a hit. For a servicer with $50B in FHA loans, a 1% uptick in delinquencies could mean $500M in advances tied up longer than planned, straining liquidity and raising borrowing costs.

   
   

Potential Servicer Loss

For a large servicer—one handling 100,000 FHA loans—a rough estimate:

Potential Servicer Risk	Amount	Summary
Penalties	$1M-$5M	For systemic non-compliance
Foreclosure Costs	$40K each	1,000 extra foreclosures: $40M
Denied Claims	$50K each	500 rejected claims: $35M
Missed Incentives	Payment Supplements @ $1,750 each	5K missed: $8.75M
Operational Fixes	$2M-$5M	Rushed tech and staffing
Total Potential		$80M to $100M

If the servicer’s portfolio is more extensive or delinquently increases, the losses could be even more significant. The real unknown is the regulatory response—HUD may escalate to suspending FHA servicing rights, which would severely impact the servicer’s business model overnight.

Refined Estimate

1. Base Case: $1.5M (penalties) + $13M (defaults/foreclosures) + $10M (claims) + $1.75M (incentives) + $1.2M (ops) = $27.45M.

   
   

2. Low End: $1.5M + $8M + $5M + $875K + $800K = $16.175M (fewer foreclosures, claims issues).

   
   

Workflow Changes for Servicers

Extended COVID-19 Recovery Options (Through Feb 2026) 

What’s Happening: Servicers can continue using temporary COVID-19 loss mitigation tools—like extended forbearance or repayment plans—beyond their original expiration. This extension gives borrowers more time to stabilize but keeps servicers in a holding pattern.

Workflow Impact: Servicers must maintain dual tracks—processing permanent loss mitigation options while offering these temporary measures. This means updating systems to track eligibility (e.g., COVID-specific relief vs. standard options) and training staff to explain both.

Refined Loss Mitigation "Waterfall" 

What’s Happening: The updated waterfall prioritizes home retention with stricter rules: one retention option every 18 months, a three-month trial payment plan requirement, and borrower attestation of affordability. It’s a more structured, less flexible sequence.

Workflow Impact: Servicers will need to overhaul their decision trees. Each borrower case now requires:

•      Checking the 18-month lookback period for prior interventions.

•      Collecting and verifying attestation documents.

•      Setting up and monitoring trial payment plans before finalizing modifications.

This adds steps to the process, increasing documentation and compliance checks. Servicers can’t fast-track a modification anymore—they’re locked into a slower, more deliberate workflow.

Payment Supplement Program Continuation (Through April 2025) 

What’s Happening: This lets servicers reduce monthly payments by up to 25% for borrowers in arrears, using a partial claim to cover past-due amounts without altering the principal.

Workflow Impact: Servicers must integrate this into their toolkit, which involves:

•      Identifying eligible borrowers (those with enough equity for a partial claim).

•      Calculating the payment reduction and processing the claim with HUD.

•      Adjusting payment schedules and communicating changes to borrowers.

It’s an additional option to manage, requiring precise coordination with FHA claims systems and borrower outreach to ensure uptake.

Operational Changes for Servicers

System Updates and Data Management 

The new rules demand robust tracking—18-month histories, trial plan performance, attestation records, and Payment Supplement eligibility. Servicers will need to upgrade software or retrain staff on existing platforms to handle these layers. This isn’t just a tweak; it’s a significant data overhaul to stay compliant and audit-ready.

Staff Training and Capacity 

Servicers must retrain teams on the updated waterfall, trial plan requirements, and extended COVID-19 options. With more steps and stricter criteria, staff must be sharper on FHA guidelines to avoid errors that could delay relief or trigger penalties

Borrower Communication 

The changes mean more touchpoints with borrowers—explaining trial plans, collecting attestations, or pitching the Payment Supplement.

Compliance and Reporting 

The FHA is tightening oversight. Servicers must submit detailed data on loss mitigation outcomes, trial plan success rates, and claims filed. This ups the administrative burden, requiring tighter internal controls and potentially more audits from HUD.

The problem within existing frameworks:

• Scale of Change: The workflow adjustments and operational demands touch every delinquent loan case. For a large servicer, this compounds quickly.

• Time Pressure: The extension to Feb 2026 for COVID-19 options buys some breathing room, but the Payment Supplement’s April 2025 cutoff adds urgency.

• Risk Factor: Stricter rules reduce flexibility, increasing the chance of errors or delays if servicers aren’t prepared.

• Cost Implications: Updating systems, training staff, and hiring extra hands (if needed). Smaller servicers will feel this more acutely.