Mortgage relief options: Refinancing versus loan modification

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With more than 22 million Americans applying for unemployment in the last month and nearly three million putting their home loans on pause, mortgages have become a hardship for many. This has prompted government agencies as well as private lenders to help homeowners out of the deep end with options like mortgage forbearance while the country is crippled by the coronavirus pandemic.

Mortgage forbearance allows borrowers to pause payments and make them up later; forbearance repayment options depend on who owns your loan.

But, as the pandemic drags on, some borrowers will need a more permanent solution that allows them to lower their mortgage payments. Here’s everything you need to know about these options.

Lowering mortgage payments based on your situation

There are two key ways borrowers can permanently reduce their mortgage payments: mortgage refinance or loan modification. They both achieve essentially the same result — lower monthly payments, but their requirements and how they affect your credit report are different.

Mortgage refinance allows borrowers to retire their existing loan and take out a new one with more favorable terms. This process requires borrowers to apply for a mortgage by submitting proof of income and their credit report; whereas loan modifications change your existing mortgage and don’t require minimum credit scores or income to qualify, however, they might show up as a negative event on your credit report.

Refinancing can save you money, and preserve your credit

Mortgage interest rates have seldom been more friendly to borrowers, staying consistently below 4 percent and even dropping into the low 3s some weeks for the 30-year fixed.

Millions of Americans can save by refinancing, which can shave hundreds of dollars each month from mortgage payments.

For example, if you owe $200,000 and your interest rate is 4.5 percent, your monthly payment is around $1,013 each month. If you refinance and lock in a 3.5 percent interest rate, your mortgage payment drops to $898 per month. You can see your savings with different interest-rate scenarios here.

Refinancing, however, is not cheap. Closing costs are typically 2 to 5 percent of the loan. So, if you were to refinance your $200,000 mortgage, you could pay $4,000 to $10,000. There are “no-closing cost” refinancing options that allow borrowers to either pay a higher interest rate or roll the closing costs into the loan amount.

To get the lowest rate available, borrowers must have excellent credit and proof of income. Borrowers who are unemployed or have been furloughed due to the coronavirus can’t use unemployment insurance as proof of income, even if they’re guaranteed a job when business reopens, says Julie Aragon, owner of Julie Aragon Lending in Santa Monica, California.

“The only people who can use unemployment insurance as proof of income are seasonal workers,” Aragon says. “These are people who have shown a pattern of work mixed with downtimes where they supplement their income with unemployment.”

Mortgage refinancing can be a good option for folks who have high FICO scores and stable income. It doesn’t show up on your credit report as a negative event and borrowers can choose to tap their equity with a cash-out refinance, if they have sufficient equity. For those who have missed payments or have suddenly lost income due to the pandemic, a loan modification might be a better solution.

When loan modifications make sense

A loan modification changes the terms of the loan so it’s more affordable for borrowers who are dealing with economic hardship. Lenders can reduce the interest rate, extend the terms or change the loan type (or do a combination of all three), in order to make the loan more manageable for the borrower.

Modifications are attractive because they’re not dependent on credit score or income and are designed to prevent foreclosure.

The difference between a loan modification and a refinance loan is that modification adjusts your current loan while refinancing replaces your existing loan with a new one. Additionally, loan modifications come with nominal charges, usually a small administration fee instead of hefty closing costs, like refinancing.

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.

The downside is that loan modifications 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.

Who qualifies for loan modifications? They’re available to both distressed and nondistressed borrowers. Generally, borrowers must show a history of missed payments or imminent danger of foreclosure, says Mike Tassone, COO of Own Up, a mortgage fintech company.

The terms of loan modifications depend on the borrower. In many cases, a loan modification starts as a trial run for a few months and then is made permanent.

“Loan modifications can often be processed within a few days with little to no paperwork for borrowers in good standing. On the downside, lenders may not offer the lowest market rate and a borrower may do better with a refinance at another lender. In addition, non-distressed loan modifications do not allow borrowers to take cash,” Tassone says.

The FDIC supports loan modifications for borrowers

Struggling homeowners who lived through the financial crisis might be worried about what will happen to their homes in today’s world where economic recovery is uncertain. However, this is a different time, says Pete Carroll, executive, public policy & industry relations with CoreLogic.

“There’s no doubt that the financial crisis of 2008 was very different than today. I think the legitimate concern people express is PTSD from the financial crisis,” Carroll says. “When everything went bust people just walked away from the loan. Servicers didn’t know if you were a strategic defaulter or you were legitimately crushed by the financial crisis. Today, most lenders know that borrowers are being hit hard by the pandemic.”

A positive sign of relief for borrowers is the FDIC’s support of loan modifications for homeowners who need it. Recently, the FDIC issued a statement to financial institutions urging them to work with borrowers struggling to keep up with their home loans.

“The agencies encourage financial institutions to work prudently with borrowers who are or may be unable to meet their contractual payment obligations because of the effects of COVID-19. The agencies view loan modification programs as positive actions that can mitigate adverse effects on borrowers due to COVID-19,” the FDIC stated.

The statement is an important step in helping borrowers while assuring banks that they won’t be dinged by regulators if they do modify, says Brian Sullivan, a spokesperson for the FDIC.

“By relaxing these standards, this is not just spoken encouragement, it’s actual encouragement for banks to issue loan modifications,” Sullivan says.

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Written by
Natalie Campisi
Mortgage reporter
Natalie Campisi is a former mortgage reporter at Bankrate.
Edited by
Senior mortgage editor
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