Loan modification is an option if you’re looking to lower your monthly loan payments. It can help reduce your payments. Why should you choose loan modification? What is it and how does it work?
What Is a Loan Modification and How Does it Work?
A loan modification may be a good option if you’re struggling to meet your loan payments and if you’re looking for ways to prevent a home foreclosure. Many lenders agree to a loan modification to avoid the expenses and hassle involved in seizing and reselling a foreclosed property.
Loan modification involves changing the terms of your original loan. You can ask your current lender if they offer this option. The new loan conditions will only take effect if your lender approves them.
You can use a mortgage modification calculator online to get an estimate of your monthly payments, interest rate, and the loan-to-value ratio.
Keep in mind that your lender isn’t required to accept your request to modify your loan. Lenders have their own set of requirements and offerings when it comes to loan modification.
How to Get a Loan Modification
Here are the steps to getting a loan modification:
- Contact your lender.
- Explain your current financial situation.
- Request for a loan modification.
- Provide proof of financial hardship, if requested by your lender.
- Provide a letter explaining why you need a loan modification, if requested by your lender.
- Submit all the information and documents you need to demonstrate your current financial situation.
- Wait for your lender’s decision.
What Are The Changes Involved In Loan Modification?
- Loan Term
Your loan term may be extended so you’ll have more time to pay back your loan while lowering the amount that you have to pay every month.
- Interest Rate
The interest rate may be reduced if your loan is modified. A lower interest rate may also lower your monthly payments.
- Loan Structure
If your loan has an adjustable interest structure, a loan modification may change it to a fixed interest structure. With a fixed interest rate, the amount you need to pay every month will be more predictable.
- Principal Forbearance
Your lender may agree that you pay a part of your principal balance at a later date. This will help make your loan more manageable by reducing your monthly payments.
How Is Loan Modification Different From Loan Refinance?
Now, let’s talk about loan modification vs refinance. A loan modification involves changing the original terms of your loan with your existing lender.
On the other hand, refinancing replaces your existing loan with a new mortgage.
Unsatisfied with your lender? A refinance can allow you to switch to a new lender’s system. This allows you to change the terms of your loan. You can also use your equity to take cash out of your home.
You might want to refinance to:
- Lengthen your mortgage payment term
You lower your monthly mortgage payment when you refinance to a longer mortgage term. This can help you avoid foreclosure if your income is now lower than when you got your loan.
- Shorten your mortgage payments
You can also shorten your existing mortgage term with a refinance. Your monthly payment increases when you shorten your term. However, you own your home sooner and save money over time in interest.
- Take a lower interest rate
Mortgage refinancing can help you lock in a lower rate if interest rates are lower now than when you got your loan.
- Change your loan type
It might be beneficial to refinance to a new loan type if you have more than 20% equity in your home. For example, if you have an FHA loan, you’ll pay for mortgage insurance throughout the life of the loan if you put less than 10% down.
However, you can cancel private mortgage insurance on a conventional loan as soon as you reach 20% equity. Many homeowners refinance their FHA loan to a conventional loan after they achieve 20% equity for this same reason.
- Take a cash-out refinance
A cash-out refinance allows you to draw money from your home equity to cover outside expenses. You take on a higher-balance loan and in exchange, your lender gives you the difference in cash.
For example, imagine that your principal loan balance is $200,000 and you want to cover $20,000 worth of credit card debt with your equity. A cash-out refinance means you’d take a loan with a $220,000 balance and your lender would give you $20,000 in cash.
Mortgage interest rates are lower than the interest rates on other types of loans and credit cards, which allows you to save money when you cash out.
When Should You Consider Loan Modification?
- You’re missing your monthly mortgage payments
Your lender is unlikely to grant your request for a loan modification unless you’re already behind on your payments. Request for a loan modification if you’re unable to catch up on your payments unless adjustments to the terms are made.
- You need to reduce your principal balance
A loan modification may help make your payments more manageable especially when you hold too much debt on your home and it’s at risk of getting foreclosed.
- You’re going underwater
Loan modification programs can help prevent your home from going underwater (the loan is bigger than the value of the property). Negotiate with your lender and come up with better loan terms so that you don’t miss payments, which will only lead to bigger debt.
- You’re facing financial hardship
You can prove that you’re experiencing financial hardship due to disability or illness, natural disaster, death of a family member, divorce, and an unexpected increase in housing costs.
What Are The Benefits Of A Loan Modification?
A loan modification offers mortgage relief to consumers who are financially stressed. If your loan modification request is approved, you’ll enjoy several benefits such as:
- Lower interest rates
- Change variable rates to fixed rates
- Extend loan term length
- Lower monthly payment
- Avoid home foreclosure
What Are The Drawbacks Of A Loan Modification?
A loan modification may prevent your home from getting foreclosed but it also comes with certain drawbacks.
Changing the conditions of your loans specifically, extending the loan’s term, will cost you more in the long run. If you add more years to your loan, you’ll have to pay more interest, making this option an expensive lifeline for you if you’re already struggling financially. But it does offer you temporary relief, especially if you are unable to pay your mortgage comfortably.
The loan modification process can be time-consuming and stressful. Depending on your lender, you may be required to gather several documents such as your tax returns and bank statements, which can be tedious and frustrating.
What Are the Loan Modification Requirements?
Lenders have different standards when it comes to mortgage loan modification requirements. Generally speaking, they require documents that will support your claim regarding your current financial standing. These include the following:
- Proof of income
- Tax returns
- Bank statements
- Hardship letter
How Many Loan Modifications Are You Allowed?
There’s no official limit to how many times you can request a loan modification from your lender. The rules will depend on your lender and your situation. It also varies from one financial institution to another.
How Does A Loan Modification Affect Your Credit?
Lenders may report the loan modification to the major credit reporting agencies. It will leave a negative mark on your credit report but its effect will be less severe than the damage that a foreclosure may cause to your credit score.
As mentioned earlier, some lenders won’t consider your loan modification request unless you’ve already missed payments. Your credit report will show these missed payments along with the loan modification.
As long as you follow the loan modification terms and you make timely payments, you’ll manage to rebuild your credit within a few years. This outcome is better than having a foreclosure listed on your credit report, which will remain as a derogatory mark for seven years.
Also, a foreclosure is a red flag for lenders, which could make it harder for you to secure approval on your future loan applications.
What Are The Alternatives To A Loan Modification?
In case you don’t qualify for a loan modification, there are other options that you may consider.
1. Repayment Plans
Repayment plans are an option if you have missed a few payments but can afford to resume repayments even if it means paying higher. A repayment plan means your monthly repayments will be increased temporarily until you’ve covered the amount plus interest that you failed to pay. Once you’ve brought your account current, the amount you have to pay per month will be returned to normal.
2. Mortgage Forbearance
A mortgage forbearance plan will reduce or suspend your payments for up to 12 months. Once that period is over, you need to resume the regular monthly payments and pay back the amount that was excused during the forbearance period.
This program is an excellent solution if you’re facing temporary financial struggles since you don’t have to pay any fee or additional interest.
3. Bankruptcy
If you’re unable to secure a loan modification or can’t refinance your loan, you may consider filing for Chapter 13 bankruptcy. This type of bankruptcy involves creating a court-approved repayment plan to help you pay off your debts within 3 to 5 years.
Conclusion
A loan modification is different from refinancing. The former involves modifying the terms of an existing loan with your current lender. It’s an option for borrowers who are at risk of facing foreclosure or those whose loans are underwater.
The latter, on the other hand, involves replacing your existing loan with a new one from your existing lender or a different creditor. The new loan will have more favorable terms and you may even cash out your home equity. However, you need to go through the whole process of taking out a new loan, which may be difficult if you don’t have a good credit standing.
Loan modification and refinancing can be the answer if you’re looking for a way to reduce your monthly loan payments. They both have pros and cons, which you need to know so you can determine which option is best for your situation.
Aidan has been writing about personal finance for over 6 years. Prior to this, he worked as a Corporate Finance Analyst where he specialized in Due Diligence, Company Valuations and more. He is a CFA charterholder.
