A mortgage modification can permanently reduce your monthly payment, but there are downsides to consider

A mortgage modification can permanently reduce your monthly payment, but there are downsides to consider

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  • A loan modification is an agreement between a borrower and a lender to permanently change the terms of a mortgage loan.
  • You will need to prove financial hardship in order to qualify for a loan modification.
  • Loan modifications can help you keep your home, but may result in a longer repayment period.

If job loss, natural disaster, illness, or other unforeseen circumstances cause your mortgage to fall behind, a loan modification could be a good long-term solution.

Changing the terms of your loan, such as the interest rate or repayment term, to lower your monthly payment can provide relief if you’re late and help you avoid more serious situations, such as foreclosure.

However, there are some potential negative consequences of a loan modification that you should keep in mind.

What is a mortgage loan modification?

A loan modification permanently changes the terms of your home loan to make it easier to manage payments. You will need to prove significant financial hardship to qualify for a loan modification, usually through documentation such as a letter of termination from an employer or copies of medical bills.

Generally, borrowers can only get a loan modification if they are at risk of foreclosure. If you’ve missed enough payments to cause your lender to consider foreclosure, a loan modification may be the only way out.

Loan modifications are more common if a borrower was temporarily unable to pay their mortgage and expects circumstances to improve, says real estate attorney David Reischer. For borrowers who seem able to get back on track, a lender might prefer loan modification to the expense and hassle of foreclosure.

Lenders and banks are not obligated to accept a loan modification, however.

“Lenders will generally refuse a loan modification if a borrower is unemployed and the likelihood of the loan going back into default is high,” Reischer said.

And if your lender has already started the foreclosure process, a loan modification might not automatically stop the process.

If you’re considering a loan modification, get expert advice. Walter Russell, president of financial advisory firm Russell and Company, says that since every mortgage situation is unique, you should speak to an accountant or financial advisor about your options.

Types of Loan Modifications

Common types of mortgage modifications include extending the term of the loan, lowering the interest rate, or changing from a variable rate mortgage to a fixed rate mortgage.

Here are the types of modifications available for the three most common types of mortgages:

  • Conventional loans: Modifications may include a Freddie Mac or Fannie Mae Flex modification, which may be an extension of loan term, reduction in monthly payment amounts, reduction in interest rate, partial forbearance on principal, or passage of a variable rate mortgage to a fixed rate mortgage.
  • FHA Loans: Potential FHA changes include adding missed payments to the original principal and extending the term to 30 years at a fixed interest rate. Another option is a “partial claim”, which is an interest-free subordinate lien on the property, payable at the end of the loan term or upon sale or refinance. Changes and partial claims can be combined. HUD also announced a new 40-year mortgage modification for certain borrowers as part of its COVID-19 recovery assistance.
  • VA Loans: VA loan modifications can allow the borrower to add missed payments and any related legal fees to the mortgage balance, then agree with the lender on a new payment schedule.

Loan modification vs refinancing

More borrowers may be familiar with the concept of refinancing, which can have similar results to a loan modification. However, it is not exactly the same process.

A loan modification works with your original mortgage and makes adjustments to things like loan term or interest rates. Unlike a loan modification, refinancing creates an entirely new loan that replaces the old one (and pays off the original debt).

Justin Pritchard, a CFP® professional at Approach Financial Planning, says that since loan modifications can hurt your credit, it may be worth considering first whether refinancing is a possibility.

However, the qualifications for refinancing are generally stricter. If you don’t qualify for refinancing due to missed payments or income requirements, a loan modification may be your only option.

Loan modification vs forbearance

Another option similar to loan modification is forbearance. Unlike a loan modification, forbearance involves the creation of a new loan agreement, but only temporary.

When you accept a forbearance, your lender will allow changes to the terms of your loan for a fixed term. Much like the federal student loan forbearance program implemented during the COVID-19 pandemic, a mortgage forbearance gives borrowers a break from their payments.

Forbearance does not erase what you owe on the mortgage. It provides leeway to help you get back on track with your past and future payments. Loan modification may be preferable to forbearance if you need a permanent solution to lower your monthly payment.

Advantages and disadvantages of loan modification

For borrowers facing extreme hardship that prevents them from making mortgage payments on their current loan terms, a loan modification may be the answer. Loan modification has its downsides, however.

Is loan modification a good idea?

A mortgage loan modification can be a reasonable solution for borrowers who are struggling to keep up with payments. If long-term financial difficulties have made it difficult or impossible to pay off your mortgage as provided for in the loan, making changes to the existing loan terms could help you stay in your home.

Depending on your situation, says Pritchard, a loan modification might be the “least worst” option. Extending your loan term may offer a lower monthly payment but higher total interest charges, he says. This can make your home more expensive in the long run and isn’t necessarily the best solution. The likely drop in your credit score is another pitfall to watch out for. A lower credit rating will make future borrowing more difficult.

However, the alternatives — like a foreclosure or short sale of your home — would stay on your credit report for years and could have other financial impacts. Loan modification allows you to avoid these more drastic consequences.

Russell suggests considering other options before settling on the loan modification, such as downsizing or finding additional revenue streams.

Frequently Asked Questions

A loan modification is a permanent change to your mortgage agreement. The length of time it takes to get a loan modification approved can be several months.

Is a loan modification hurting your credit?

Getting a loan modification usually results in a drop in your credit score. However, this may be temporary, especially if you resume payments and work otherwise to improve your credit.

Banks and lenders are generally not required to authorize loan modifications. However, since foreclosure can be costly, banks may prefer to accept loan modifications in order to retain a customer.

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