What is a loan modification?
Mortgages are long commitments — and we stress the word “long” here. In many cases, borrowers agree to 15- or 30-year loan terms. So, when you’re not happy with a particular aspect of your mortgage, you might feel trapped with no recourse but to soldier on and just cope with it.
But what if you could change the terms of your mortgage without going through a full-fledged refi? Would you shorten your amortization schedule? Lower your interest rate? The possibilities aren’t exactly endless, but they are plenty enticing.
It can be hard to choose between a loan modification and a traditional refinance — not to mention your third option: standing pat and doing nothing at all. Our loan modification guide is here to help you make sense of mortgage modifications: how they work, how they compare to refis and when you should use them.
What is a loan modification on your mortgage?
A mortgage modification changes the terms of your home loan, often with the goal of easing the borrower’s financial burden and making it easier to repay the outstanding balance of the loan. Lenders may find that changing those loan terms, even if it means bringing in less money from the mortgage, is preferable to going through the foreclosure process.
In some cases, home loan modifications are only available to borrowers who are at a high risk of default. In fact, you may need to show your lender that you simply cannot afford to repay your home loan with the existing terms. But the exact qualifications you need to meet to be eligible for a loan modification varies from lender to lender. That’s assuming the loan is held in portfolio by the lender. If your lender has sold your home loan as part of a mortgage-backed security — and they almost certainly will — then loan modification terms will be managed by the owner or investor of the loan.
What loan terms can you change with a mortgage modification?
Loan modifications frequently focus on terms regarding your mortgage payments. With that in mind, these are some of the most common loan terms borrowers look to amend through a mortgage modification:
- Interest rate: Lowering your interest rate could help bring your monthly mortgage payments down so fit your budget.
- Loan length: Rather than shorten the life of the loan, borrowers may look to extend it. Although you’d likely pay more over the long run, this move would also reduce your monthly payments.
- Amortization schedule: Adjusting your amortization schedule could be a good way to spread out the cost of late fees and missed payments across the life of your loan.
- Principal balance: Although a pretty rare occurrence, lenders may agree to lower the principal owed on a home loan.
- Late fees: When late fees pile up, it can be tough to get ahead on your mortgage. You may be able to adjust late payment penalties or incorporate them into your monthly mortgage payments.
- Loan type: Usually, borrowers who want to switch loan types refinance the mortgage. In some cases, however, you can apply for a loan modification to go from a fixed rate mortgage to an adjustable rate mortgage (ARM) or vice versa.
What happens when you get a loan modification?
If you’re interested in a loan modification, then you’ll need to reach out to the servicer on your home loan. Now, that might be your original lender. But if they have given up their mortgage servicing rights — which may happen when lenders sell mortgage-backed securities on the secondary market — then you’ll need to approach your loan servicer. They can help you determine if the owner or investor of your loan will consider a modification of loan terms and what circumstances or conditions you’ll need to meet.
If they do allow loan modifications, you’ll first need to make a case for why you deserve one. That means documenting whatever financial hardship is preventing you from paying your mortgage each month. Borrowers applying for a loan modification are often required to fill out a “hardship statement” detailing your financial situation.
You’ll also need to submit documents like bank statements, pay stubs and tax returns that will give your lender more insight into your finances. Lenders want to see that you’re living within your means before making a decision. If you have a high debt-to-income (DTI) ratio, for instance, then there could be some valid concerns about your ability to repay your loan — with or without a mortgage modification.
If the lender agrees that you qualify for hardship assistance, you’ll be approved for a loan modification. If not, you can appeal the decision and restate your case.
How do you qualify for a mortgage modification?
If — and we stress if — your lender allows loan modifications, it will be in cases where homeowners are struggling to keep up with monthly mortgage payments. Often, that financial difficulty is the result of forces outside of your control.
Every lender will have their own conditions for accepting a loan modification. For instance, Freddie Mac requires borrowers to be at least 60 days behind on mortgage payments to qualify for its Flex Modification program. But there are some common scenarios where borrowers can apply for one.
wHEN MIGHT YOU QUALIFY FOR A LOAN MODIFICATION?
- Drop in income level, usually as a result of a salary decrease or change in employment
- Debilitating injury or illness that affects your job prospects
- Dissolution of marriage where both parties share housing costs
- Unexpected increase in housing costs, such as a dramatic change in assessed property taxes or homeowners association fees
- Death in the family that impacts the household’s income
- Extensive property damage caused by natural disasters or otherwise not covered by insurance
- Public health crisis — think: the COVID-19 pandemic
Keep in mind that the lender’s goal here is to help you repay your loan, not absolve you entirely of your financial responsibilities. Mortgage lenders aren’t going to offer a loan modification if it seems unlikely the borrower will be able to repay the loan even with those changes. So, if you lose your job and you don’t have any income coming in to pay your home loan, a mortgage modification could be a pretty hard sell.
How do loan modifications affect your credit?
The impact that a mortgage modification has on your credit could be minimal if your lender doesn’t classify the change as a type of settlement when reporting it to credit bureaus. You might even see your credit score increase slightly because your monthly housing costs are going down, but that’s not very common.
You should probably prepare for the more likely scenario in which your lender does report your loan modification as a settlement or adjustment. In that case, you would almost certainly see a negative impact on your credit.
Here’s the thing, though: Whatever dip in credit score you experience as a result of a loan modification will likely be only temporary. As you get a handle on your mortgage payments and settle into spending habits that fit your income level, your credit situation should sort itself out.
Also, any hit to your credit as a result of a loan modification will pale in comparison to the fallout from defaulting on your mortgage. If you have to pick one of those two options, the choice is crystal clear.
Loan modification vs. refinance
If you’re unhappy with the terms of your mortgage, a loan modification isn’t your only option. Heck, it’s not even the most popular one. Refinancing your mortgage is a much more common method to alter your home loan and receive more favorable terms like a lower interest rate or shorter amortization schedule. How do these two approaches stack up?
- Timing
- Principal
- Credit score
- Eligibility
- Costs
Timing
Refinancing your mortgage can be a lengthy process, taking anywhere from 30 to 45 days, on average, to complete. Keep in mind that when you refinance, you’re applying for a completely new mortgage, so you need to go through the whole gamut of underwriting review and approval before your new loan terms can be finalized. The good news is that with a reliable lender, the mortgage process will run like clockwork, so you can almost guarantee that it won’t take longer than 45 days to get refinanced.*
That’s not always the case with loan modifications, which are processed less frequently. You could receive your mortgage loan modification in as little as 30 days. Or you could be left waiting upwards of 90 days for everything to go through. It really comes down to the individual lender and their ability to quickly process mortgage modifications.
Principal
The principal owed on your home loan will always stay the same when you refinance your mortgage. Other loan terms — interest rate, length of the loan, even the loan type — can change, but the principal almost always remains the same. The only exception would be if you have cash on hand to pay the difference between the new loan and the old loan. Then you could finance a smaller amount of the loan.
Even though loan modifications would seem to have the edge in this regard, reducing your principal is such a rare occurrence that you probably shouldn’t put too much emphasis on it when weighing your financial assistance options.
Credit score
We’ve already noted that there’s a good chance your credit score will take an initial hit when you apply for a loan modification. Again, that’s because your lender will most likely report the change to credit bureaus as a settlement or adjustment to your home loan.
The impact on your credit will be less noticeable if you refinance. Although the underwriting process involves financial reviews and credit inquiries, it’s not as damaging as a settlement on your file. Of course, compared with a foreclosure, either option is much preferable when it comes to your credit, to say nothing of your long-term financial outlook.
Eligibility
When homeowners refinance, it’s usually with the intention of reducing interest rates and, by extension, monthly mortgage payments. Although there are a lot of factors — both macro and micro — that lenders consider when setting interest rates, your financial situation is going to be heavily weighted in that decision. The less debt you have, the less risk you pose to the lender. And that usually means a lower interest rate. So, lenders are more likely to extend more favorable refinancing terms to borrowers with stable finances.
Those eligibility requirements may exclude the people who would benefit most from mortgage modifications. After all, if you’re behind on your mortgage payments and are struggling to keep up with basic living expenses, lenders are probably not going to see you as a low-risk borrower. And that means your prospects of getting a lower interest rate on a refinance could be pretty slim.
With a loan modification, the situation is flipped. You need to demonstrate to your lender that your financial situation is so dire that it’s a matter of when — not if — you default on your mortgage.
Costs
Refinancing is frequently viewed as a money-saving move for homeowners, but there is an up-front cost to pay. As with any new loan, you’ll need to pay certain closing costs like origination fees, appraisals and title insurance. Those could add up to thousands of dollars paid out of pocket by the borrower.
Conversely, there are no extra costs to pay with a loan modification. In fact, lenders that participate in government programs like the Home Affordable Modification Program actually receive financial incentives to help financially distressed borrowers by changing the terms of their home loans.
When should you consider a mortgage modification?
A loan modification is a pretty extreme step to take — at least in the eyes of mortgage lenders. They’ll likely view it as a last resort to put borrowers in a better position to make timely mortgage payments and repay the full loan amount.
iS A LOAN MODIFICATION RIGHT FOR YOU?
You should only really turn to a mortgage modification if you’ve fallen behind on your payments and want to avoid foreclosure. Remember: You’ll need to show your lender evidence of your money struggles, whether that’s pay stubs reflecting reduced wages or bank statements demonstrating a sudden, unexpected loss of income.
If you’re up to date with your mortgage payments, and just want to lower your interest rate or switch to a different type of loan, then refinancing is the way to go.** No lender is going to sign off on a modification request without clear documentation of financial hardship.
In conclusion
Loan modifications enable borrowers to change mortgage terms after the fact, altering everything from interest rates to loan length. In some extreme cases, you may even be able to reduce the amount of principal you owe on your mortgage.
Lenders only agree to loan modifications when borrowers can show evidence of financial hardship and the inability to repay the original loan amount. As such, you should consider a mortgage modification as a last-ditch effort to avoid foreclosure.
There are far easier ways to lower your interest rate, shorten your amortization schedule or switch to another type of loan. If that’s what you’re interested in, and you have a healthy financial situation, then you should explore a refi first.
*Rate cannot guarantee that an applicant will be approved or that a closing can occur within a specific timeframe. All dates are estimates and will vary based on all involved parties level of participation at any stage of the loan process. Contact Rate for more information.
**Savings, if any, vary based on consumer’s credit profile, interest rate availability, and other factors. Contact Rate, Inc. for current rates. Restrictions apply.
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