How does a loan modification work, and when should you choose it over a mortgage refinance?

Loan modification and refinancing are two options if you’re looking to lower your monthly loan payments. Both help reduce your payments but they differ in terms of their requirements and their effect on your credit report.

A loan refinance allows you to retire your current loan and secure a new loan that comes with more favorable terms. You have to go through the same process of applying for a new loan, with your current lender or with a new creditor, which means you need to submit proof of income, your credit score will be checked, and so on. Meanwhile, a loan or mortgage modification doesn’t need all that. As its name suggests, your existing loan will be modified by your current lender with terms that can help you manage your payments better.

What is 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.

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.

What are the Benefits of a Loan Modification?

A loan modification offers 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 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.

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.

When Should You Request a Loan Modification?

  • You’re missing your monthly 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 modifications 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.

Who Can Request a Loan Modification?

Lenders have different eligibility requirements, but the common ones are as follows:

  • You have missed payments on file or missing one is imminent.
  • You can prove 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 Requirements for a Loan Modification?

Lenders have different standards when it comes to loan modification. Generally speaking, they require documents that will support your claim regarding your current financial standing. These include the following:

Are there Government Programs for Loan Modifications?

If your loan is backed by a federal agency or program, you may consider these government loan modification options.

Fannie Mae and Freddie Mac offer a program called Flex Modification. It involves adjusting the loan terms for borrowers with mortgages that are at least one year old, missed payments, or facing foreclosure.

Struggling FHA loan borrowers may also be eligible for government relief programs such as loan forbearance. It involves reducing or suspending your monthly payments for a certain period (up to 12 months). Once that time has passed, you will resume regular payments including the payments that were excused. Borrowers don’t have to pay additional interest in a loan forbearance.

Military veterans, active service members, and surviving spouses who have VA loans may apply for loan modification programs to avoid foreclosure. They may also get mortgage delinquency counseling with the help of the US Department of Veterans Affairs.

What Does the FDIC Say About Loan Modifications?

The Federal Deposit Insurance Corporation (FDIC) supports financial institutions that offer loan modification to borrowers who need it. In a recent statement, the FDIC encouraged lenders to work prudently with people who are unable or may be unable to meet their payment obligations due to the effects of the pandemic on their financial health.

The FDIC considers loan modification as positive actions that can help mitigate the negative effects of COVID-19 on borrowers. It also reassured banks that regulators won’t ding them in case they offer loan modification programs.

What is Refinancing?

Refinancing involves rolling over your current loan into a new one from the same lender or a different creditor. Borrowers choose to refinance their loans so that they could get more favorable borrowing terms, such as lower interest rates and monthly payments.

Can you refinance after a loan modification? The answer is yes. A loan modification doesn’t disqualify you from applying for refinancing. However, you need to meet the requirements set by the lender to be approved.

There are 3 types of refinancing:

1. Rate-and-term Refinance Loan

This type of refinancing involves changing the loan term and/or the interest rate while retaining the current loan amount. It’s a good option if you prefer to have a fixed-rate loan structure and you want to save on your monthly payments.

2. Cash-Out Refinance Loan

This type of loan involves cashing out a part of your home equity so that you’ll get a bigger loan amount. The amount you get to cash out is the difference between the new loan amount and your previous loan. You can use the extra money for travel, home remodel, etc.

3. Cash-In Refinance Loan

A cash-in refinance loan is the opposite of a cash-out refinance. It involves refinancing your mortgage and paying additional money during the refinance transaction to lower your new mortgage balance. This is a good option if you want to eliminate private mortgage insurance or keep your monthly payments low.

When Should You Refinance?

There are many reasons why you should refinance your loan.

1. Lower Monthly Payments

Refinancing your loan can help lower your monthly mortgage payments if you find a lender that offers lower interest rates. You can also achieve this by extending the loan term. However, you’ll pay more interest over time.

2. Tap Into Your Home’s Equity

You can use your home’s positive equity to get some extra cash by refinancing your current loan. Some lenders offer cash-out refinance wherein you refinance your current loan so you can borrow more than your current loan. Of course, the new loan amount will be based on your home’s equity. The more equity you have in your home, the bigger the loan amount you’ll get.

3. Pay Off Your Loan Faster

You can refinance your current loan if you want to pay off your loan faster. If you currently have a 30-year mortgage and you have the finances to pay it off sooner, you can have it refinanced to a 15-year loan, for example.

4. Eliminate the FHA Mortgage Insurance

If you have an FHA loan and you no longer want to pay for the mandatory FHA mortgage insurance premium, perhaps because it’s an additional expense, you can refinance your loan as long as you have enough equity.

5. Switch From An Adjustable Rate To A Fixed Rate Loan

Loans with adjustable rates mean the interest rates you need to pay for may go up or down over time. The amount you need to pay every month isn’t fixed. Refinancing the loan and switching it to a fixed interest rate will provide you with a predictable amount, which you need to pay every month.

What are the Disadvantages of Refinancing?

If you refinance your loan, you may pay more interest over time especially when you decide to find a loan with terms that are longer than what you currently have.

You may not enjoy the savings offered by refinancing because you have to pay closing costs, which range from 0% to 8%.

What are the Eligibility Requirements for Refinancing?

The qualification for refinancing a loan is similar to that of getting a new mortgage. Several factors will be considered including the following:

  • Credit history. You may need to have at least a credit score of 620 to qualify.
  • Payment history on the current loan
  • Employment history
  • Income
  • Home equity
  • Other debt

How Will Refinancing Affect Your Credit?

Refinancing a loan means the lender will do a hard pull on your credit history, which could reduce your credit score by five points or less. Your credit history will also decline because you’re taking out a new loan. As long as you make timely payments on your new loan, your credit score will improve eventually.

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.


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 current 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.

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