Loan modification and refinancing both serve the same purposes. They allow you to lower your monthly mortgage bill, your interest rate, or both. That said, different types of homeowners use these procedures.
Because these are two very different practices, you’ll want to understand both before proceeding. Let’s examine the decision between loan modification vs. refinance, and what makes them different.
What Is A Loan Modification?
A loan modification is exactly what it sounds like; you’re changing the terms of your original mortgage. This doesn’t pay off your mortgage or open a new one. It’s simply a change to the terms.
Before you get a loan modification, it’s important to know that it could cause your credit score to drop. Unless you’re already behind on your mortgage, it’s usually better to refinance. Another limitation of loan modification is that you can only get one through your original lender.
Here are some of the ways a mortgage loan can be modified:
Changes to the loan structure: If market conditions are right, you could switch from an adjustable interest rate to a fixed rate. This is helpful if you’re on a fixed income and need a consistent monthly bill.
Reducing the interest rate: If you’re already on a fixed rate mortgage, you may be able to get the rate reduced.
Changes to the loan term: If your monthly payments are too high, you could try to have the loan term extended. This will lower your monthly payments, although you’ll pay more in interest over time.
Principal forbearance: This is a less common modification where your lender agrees to set aside some of the principal and let you pay it back later. This will reduce your monthly payments, as well as your total interest. For obvious reasons, lenders are usually hesitant to agree to this kind of arrangement. You will typically only qualify if it’s your only option to avoid foreclosure, and even then, you’ll have to agree to a payment plan.
Keep in mind that your lender is not under any obligation to modify your loan. You’ve signed a contract, and you’re obligated to abide by it. That said, if the alternative is foreclosure, it’s in your lender’s interest to agree to a modification. You’ll need to provide evidence of hardship, and the standards will vary based on your lender.
In some cases, you may receive an offer from a settlement company if you’re behind on your mortgage. These companies will handle negotiations with your lender and obtain a modification. Then again, you’re oftentimes paying for a service that your lender would perform for free. Try dealing directly with your lender first, and you won’t have to waste your money.
Who Qualifies For A Loan Modification?
In order to qualify for a loan modification, you need to be in financial distress. For one thing, you’ll either need to be in default, or on the verge of defaulting. You also need to have a reasonable explanation. This could be a job loss, an illness, a disability, a divorce, or another reason for falling behind on your payments.
Types Of Loan Modification Programs
Different lenders offer different types of loan modification. They’re willing to make different changes, and they’re willing to modify the loan on either a temporary or a permanent basis. The only way to find out is to ask your lender.
Starting October 1st, 2017, Fannie Mae and Freddie Mac launched a program called the Flex Modification program. This program allows you to modify your mortgage and lower your payments – but only if your mortgage is provided or guaranteed by one of those two agencies.
Incidentally, Fannie and Freddie both offer refinancing plans in addition to loan modification. Via the High Loan-to-Value Refinance program, you can often lower your interest rate and your monthly payment.
How To Get A Loan Modification
So, how do you get a loan modification? Here are three simple steps:
Compile your financial information. If you’re having trouble paying, your lender will want to know why. Collect your tax returns, pay stubs, and any other relevant financial info. You should also write a cover letter outlining your situation.
Make a plan. Before you reach out to your lender, think about what you want to propose. Do you need a short-term payment reduction, or a long-term restructuring?
Call your lender. Now that you have all your ducks lined up, it’s time to reach out to your lender. You’ll most likely have to fill out a written application. Make sure you do this at least three months before any impending foreclosure. Otherwise, if it’s denied, you won’t get the opportunity to appeal.
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What Is A Mortgage Refinance?
A refinance is different from a loan modification because it’s entirely new mortgage. As a result, you have a few more options than you do with a modification. These include:
Changes to the loan type. For example, you might have an FHA loan, which requires you to pay for mortgage insurance through the entire duration. If you refinance with a conventional loan, you can cancel your mortgage insurance once you’ve paid 20% of the home’s value.
Reductions to the interest rate. If rates are lower now than they were when you started you mortgage, a refinance can save you a bundle.
Changes to the mortgage term. With a shorter term, you’ll make higher payments, but you’ll pay less in total interest, and you’ll own your home sooner. With a longer term, you’ll pay more over time, but your monthly bill will be lower.
Get cash now. If you already have a lot of equity in your house, you can take a cash-out refinance. For example, say your home is worth $200,000 and you have $100,000 in equity. You could refinance the house, and take that $100,000 in cash. Because your house backs the loan, you’ll typically get a lower interest rate than you would if you’d taken a personal loan for the same amount.
Change lenders. Maybe you’re not happy with your lender’s customer service or business practices. You can refinance with a different lender, and do business with someone you like.
How To Refinance Your Loan
To refinance your loan, you’ll first need to choose a lender. Shop around, and see who’s offering the best interest rates and customer service. Fill out an application, and wait for the lender to get back to you.
In most cases, you’ll need to have the home re-appraised before you get a new loan. This is so the lender can confirm your home’s value, so they know they’re not lending you more than the property is worth. After this, you’ll go through the underwriting process, and you’ll sign a final contract, just like you did when you first bought your house.
Loan Modification Vs. Refinance
Now that we understand loan modifications and refinances, let’s talk about the differences. Why would you choose one method over the other?
A loan modification is something you do when you’re in trouble. For some reason, you can no longer make your payments, and you need to negotiate a new deal. Normally, you have to show that you’re in financial distress.
On the other hand, a refinance is something you do because you want to do it. Maybe you want quick cash, or maybe you want a lower interest rate. Normally, this means you’re in good financial shape. Otherwise, no lender would want to offer you a new loan.
Let’s summarize these differences:
You keep the same loan, but with new terms
You remain with the same lender
You need to be in financial distress
You must prove hardship
Can be hard to obtain
You take out a new loan
You can choose a new lender
You don’t have to be in distress
You must be creditworthy
Easy to obtain if you have good credit
When Should You Use A Loan Modification?
If you’re in good financial shape, you can skip this section. There’s no reason to get a loan modification, and you aren’t going to qualify. But if you’re in financial distress, it’s definitely worth considering.
Loan modifications are designed as a last resort to keep you out of foreclosure. This means that you’re trying to get a lower monthly payment. This could mean taking a longer-term loan, lowering the interest rates, or other modifications.
One benefit of a loan modification is that you don’t need to have good credit. Even if your finances are a mess, you may still be able to apply. You also only pay a small administration fee, whereas a refinancing requires you to pay steeper closing costs.
Loan modifications can be temporary, to get you through a rough patch. Refinances are permanent. Loan modifications also take effect much more quickly, while refinancing can take 30 to 60 days to come into place.
Unfortunately, a loan modification will negatively impact your credit. But it looks a lot better than a foreclosure, and you get to keep your home.
What Are The Advantages Of Loan Modification?
Loan modifications are a good way to get out of trouble if you’re underwater on your mortgage. As long as you can demonstrate legitimate financial distress, you can see a lower payment as soon as your next monthly bill.
You may also get free home equity if your lender reduces your principle. That said, this is unlikely, and any debt forgiveness is treated as income for tax purposes.
What Are The Disadvantages Of Loan Modification?
Like any financial process, loan modification comes with its share of downsides. For one thing, it can lower your credit score, which will make it harder to get low-interest loans in the future. Another downside is that you can’t take cash out like you can with a refinance.
When Should You Refinance?
Refinancing is a better option when you’re not having trouble with your monthly payments. The most common reason is to get a lower interest rate. This has happened a lot during the pandemic, with interest rates at historical lows. If you’re trying to get the lowest rate, it’s wise to move fast. The Fed has already signaled that rates will be going back up again this year.
Refinancing is also a great way to pay for a remodel. If you have significant equity in your house, you can cash some of that out and use it to fund your construction. Generally, you’ll get a lower rate than you could for any other kind of loan.
You should also consider refinancing if you have an FHA loan. As long as you’ve paid at least 20% of your home’s equity, you can switch to a private lender and drop your mortgage insurance. On a high-value house, this could save you hundreds of dollars a month.
What Are The Advantages Of Refinancing?
Refinancing gives you the opportunity to shop around. If you’re not happy with your lender, now is your opportunity to look for alternatives. You can also get lower interest without having to fight your existing lender for a reduced rate.
In addition, you can take some cash out of the deal, sometimes up to the full amount of equity you have in your house. You’ll have to pay it back, but mortgage debt is cheap, and it looks better on your credit report than most other kinds of debt. And speaking of credit reports, refinancing won’t negatively impact your credit.
What Are The Disadvantages Of Refinancing?
Refinancing has its share of drawbacks. For one thing, if you’re in financial distress, you’re unlikely to qualify for a new loan. And if your credit is worse than it was when you bought your house, you’re unlikely to get a better deal.
Refinances also take longer. If you need relief on next month’s bill, it’s going to be too late. In fact, you’ll be waiting an average of two months for your new terms to kick in.
Loan Modification Vs. Refinance FAQs
Before we wrap up, let’s answer some of the most common questions about loan modifications and refinancing.
How Much Will A Loan Modification Reduce My Payment?
It depends. If you qualify for Freddie Mac or Fannie Mae’s Flex Modification program, you can expect a decrease of around 20%. Then again, certain types of loans aren’t eligible for Flex Modification. These include FHA loans, USDA loans, and VA loans. If you’re with a private lender, your mileage may vary.
Is Loan Modification Bad For Your Credit?
Yes and no. A loan modification will appear on your credit report as a kind of settlement, which will have a negative impact. That said, the impact will be less severe – and shorter – than the impact of missed payments or a foreclosure.
Can You Refinance After A Loan Modification?
Yes. That said, you probably wouldn’t want to refinance right away if you’re still in financial distress. Refinancing will make more sense after you’ve recovered financially and restored your credit. That way, you’re more likely to get better terms and lower interest.
What Are Alternatives When A Loan Modification Is Denied?
If your application is denied, you’ll have 14 days to file an appeal, after which your lender will have 30 days to consider the appeal. If that doesn’t work, you can still ask for forbearance, or file for bankruptcy as a last resort to stave off foreclosure.
Can You Reduce Monthly Payments Without Refinancing?
Yes and no. Without a modification or refinance, the mortgage payment itself cannot be reduced. However, if you’ve paid off at least 20% of your home’s equity, you can qualify to have your mortgage insurance removed. This can lower your monthly bill by hundreds of dollars.
A loan modification vs. refinance are two different things, but both of them can result in a lower monthly bill. By understanding the differences between the two, you can easily determine which is the best option for your circumstances.
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