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Borrowers who receive loan modifications that reduce loan balances and not simply interest rates are 75% less likely to re-default on their loans, according to a new study from the Federal Bank of New York.

While modifications that reduce monthly payments with principal write downs are 75% more likely to succeed in the long run, than those that don’t result in lower monthly payments, how that reduced monthly payment is achieved matters, too, according to the study.

The findings could have big implications on the government’s current loan modification effort, which focuses on offering incentives to borrowers and loan servicers, which collect and manage loan payments, to reduce monthly payments by lowering interest rates and extending the loan term.  (The Government plans to implement principal forgiveness in 2010,  on the part of banks, and borrowers who succeed in keeping up with their reduced payments can receive further incentives towards reducing their loan balance.)

The paper finds that principal reductions are more successful at avoiding re-defaults because they reduce negative equity and give the borrower a greater incentive to keep current on the loan. A loan modification that only reduces the interest rate, meanwhile, “creates an in-place subsidy to the borrower leading to a hold-in effect. That is, the borrower receives the subsidy only if he or she does not move.”

Rep. Barney Frank, who chairs the House Financial Services Committee, says they will begin implementing principal write downs as part of Troubled Asset Relief Program, or TARP. This is because they feel that there is a new wave of foreclosures to come, which are people who have received a modification in the past, but because of no write down in principal, have decided to walk away anyways.