Mortgage relief options: Refinancing versus loan modification

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The coronavirus contagion roiled the U.S. mortgage market. In the first phase of the pandemic, mortgage rates plunged to record lows, spurring a refinancing boom for homeowners who were in good financial shape.

The next stage of the post-pandemic mortgage market is on the horizon. In the spring of 2020, lenders extended generous breaks to borrowers who couldn’t pay their loans. But as those mortgage forbearance periods end, some homeowners who have yet to recover financially still need relief from mortgage payments they can’t afford. More than a million homeowners could be in a position to ask their lenders for loan modifications.

The bad news? Negotiating a loan modification can be frustrating. Requirements vary by type of loan, and lenders will inundate you with paperwork and unfamiliar jargon. Here’s everything you need to know about these options.

Loan modification vs. refinance

A loan modification and a mortgage refinance both aim for the same goal — to save you money by lowering your monthly payments. However, when it comes to which option you should choose, keep in mind that these two tactics are quite different.

A refinance is something you choose to do — if you don’t refi, the consequences are minor. You might miss out on some savings, but you won’t lose your house. A modification, on the other hand, is something borrowers are forced to do. Without a loan mod, default and foreclosure loom in the not-too-distant future.

To qualify for a loan modification, you’ll need to be behind on your payments, and you’ll probably be asked to document an economic hardship. To qualify for a refinance, you’ll need to be current on your mortgage payments and prove that you make enough money to absorb the new payments.

Key differences
Loan modification
  • Offered to struggling borrowers struggling
  • You keep the same lender
  • You maintain the existing loan, but with new terms
  • Process can be confusing and difficult to navigate
  • Must prove hardship or be behind on payments
Refinance
  • Available to borrowers in strong financial position
  • You can switch lenders or stay with your current lender
  • You pay off the old loan and start a new one
  • Easy to secure for borrowers who qualify
  • Must prove creditworthiness

When loan modifications make sense

If you sailed through the coronavirus recession with no hits to your income, and you’ve been able to stay current on your mortgage payments, don’t bother with a loan modification.

However, if you’re among the large group of Americans who lost their jobs, and you have yet to recover, a modification could make sense. While mortgage forbearance offered generous terms to homeowners who were out of work, those forbearance periods are ending — and lenders expect homeowners to resume making payments. If your finances still haven’t returned to pre-pandemic levels, you’ll want to pursue a mortgage modification.

A loan modification changes the terms of the loan so that borrowers dealing with economic hardship can afford the payments. To achieve that goal, lenders can reduce the interest rate, extend the term or change the loan type (or do a combination of all three). Some possibilities:

  • Longer loan term: If your monthly payment is too much for your post-pandemic budget, your lender might extend your term — from 15 years to 30 years, or from 30 years to 40 years. This gives you more time to repay your loan and reduces the amount of your monthly payment.
  • Lower interest rate: If interest rates are lower now than when you locked in your mortgage, you might be able to modify your loan and get a lower rate. This step lowers your monthly payment.
  • A different loan type: Perhaps your original loan was an adjustable-rate mortgage. The modification could switch that loan to a fixed rate.

Modifications are attractive to struggling borrowers because they don’t require a high credit score or proof of income. This tactic is designed to keep borrowers out of foreclosure.

One significant difference between a loan modification and a refinance loan is that a modification adjusts your current loan. Refinancing, on the other hand, replaces your existing loan with a new one. Additionally, loan modifications come with modest charges, typically a small administration fee. A refi is a new loan, so it comes with hefty closing costs.

Usually, loan modifications provide immediate mortgage relief, whereas refinancing can take 30 days or more. Borrowers can’t access cash via loan modifications (like in a cash-out refinance), but a loan modification doesn’t prevent homeowners from selling their homes.

One downside: A loan modification can show up on your credit report as a negative item. However, it’s better to have a loan modification on your report than a foreclosure or missed payments.

Pros and cons of modifying your loan

Pros

  • Lower monthly payments
  • Avoid default and foreclosure
  • Keep the same loan, with new terms

Cons

  • Must show hardship
  • Your credit score might take a hit
  • Negotiating with lenders can be a cumbersome process

How to modify your loan

Each lender has its own rules and requirements for loan modifications. Most require you to provide documentation, including a hardship letter, bank statements, tax returns and proof of income.

If you’re struggling to make your payments and you think you qualify for a modification, contact your lender and ask how to apply. Lenders aren’t required to accept your application, and your lender might reject your request. In that case, you still might be eligible for a refinance.

When refinancing makes sense

If you’re one of the fortunate homeowners who maintained your income and your credit score through the pandemic, refinancing might make sense.

The classic reason to refi is to lower your mortgage rate. In the months after the pandemic began, mortgage rates plunged to all-time lows — and refinance volumes soared. Qualified borrowers could land 30-year mortgages at less than 3 percent. Since hitting a record low in January, mortgage rates have edged up.

However, rates still remain low by historical levels. If you haven’t refinanced in the past year or two, it makes sense to look at your current loan.

Here are some reasons it can make sense to refinance:

You still haven’t locked in a historically low rate. Rates remain far below their pre-pandemic levels. Say you took a 30-year loan in late 2018 at 4.75 percent (seems hard to believe, but that was the going rate then). Your monthly payment for principal and interest is $1,565. If you refinance at 3.25 percent, you’ll chop your monthly payment to $1,306, a savings of $259 a month. Your situation may not yield such dramatic savings, so be sure to calculate your break-even point — the period of time you’ll need to make up the closing costs through lower monthly payments.

You’re renovating your house. If it’s time to update your kitchen, upgrade your bathrooms or otherwise modernize your house, mortgage money is the cheapest financing available. A cash-out refinance lets you tap into home equity to pay for construction. This makes the most sense if you have plenty of equity, and if the renovations will add to the resale value of your home.

You have an FHA loan. Borrowers who took Federal Housing Administration loans can be especially good candidates for refinancing. That’s because FHA loans include steep mortgage insurance premiums that don’t go away over the life of the loan. The mortgage insurance premium on an FHA loan is 0.85 percent per year. So on a $300,000 loan, it’s $2,550, or $212.50 a month. Eliminating that monthly fee could make refinancing into a conventional loan without mortgage insurance a good move.

Pros and cons of refinancing

Pros

  • Lower monthly rate
  • You can pull cash outYou can switch terms

Cons

  • You’ll need solid credit and income
  • Closing costs are steep
  • You’ll reset the clock on your debt

How to refinance your loan

Refinancing is essentially shopping for a new loan. Contact several lenders — comparing three or more offers can save you thousands of dollars over the life of your loan.

When you find an offer you like, you’ll have to provide the same documentation you submitted when taking the original loan — bank statements, pay stubs and tax returns. You might need an appraisal, and you’ll need to pay for title insurance. The process can take up to two months.

FAQs

How can refinancing or a loan modification affect debt?

In general, both options extend the period of time it’ll take you to repay your debt. Modifications often lengthen the term of your loan. If you refinance from a 30-year loan to a 30-year loan, you reset the payment clock. But if you prefer to reduce your outstanding debt, you can consider refinancing from a 30-year loan to a 15- or 20-year term.

Does modifying a loan hurt my credit?

Yes, modifying your mortgage can hurt your credit score. However, the hit is less severe than if you continue to miss payments and ultimately go into default.

What loan modification programs are available?

The Great Recession brought an alphabet soup of loan mod programs, including HARP and HAMP. Those programs have expired. But there are others, including Fannie Mae Flex Modification, Freddie Mac Flex Modification and the Freddie Mac Enhanced Relief Refinance Program.

Learn more:

Written by
Jeff Ostrowski
Senior mortgage reporter
Jeff Ostrowski covers mortgages and the housing market. Before joining Bankrate in 2020, he wrote about real estate and the economy for the Palm Beach Post and the South Florida Business Journal.
Edited by
Senior mortgage editor
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