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Loan modification vs. refinance: how to decide

How to choose between refinancing and loan modification

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Whether you need a loan modification or refinance depends on your financial situation. If you’re in financial distress or in imminent danger of foreclosure, your existing lender may offer a loan modification to help you work through your financial troubles. A mortgage refinance is good if you want to lock in a lower fixed rate, extend or shorten your repayment term or cash out some of your home’s equity.

If you’re struggling to make your payments because of a financial hardship or you are at risk of losing your home to foreclosure, ask your existing lender for a loan modification. Otherwise, a mortgage refinance may be a better option.


Key insights

  • Loan modifications are best for individuals in financial distress who are facing foreclosure.
  • Refinancing can allow you to change your rate or term or cash out some of your equity.
  • Seeking help from your mortgage lender before you face foreclosure may give you access to more loan modification options.

What is a loan modification?

A loan modification is when your current lender agrees to make changes to your existing mortgage, such as reducing your interest rate or revising the loan terms.

You’ll need to contact your mortgage lender to see if you’re eligible for a loan modification. Be prepared to provide your lender with documentation about the financial hardship and your current financial situation. Your lender will evaluate this documentation to determine if a loan modification will help resolve your repayment problem.

What a loan modification can do for you

If your lender decides you’re eligible for a loan modification, you might receive some of the following types of assistance:

  • Interest rate reduction: Your lender may agree to reduce the interest rate on your loan if current rates are lower than what you’re paying. The primary goal of this type of modification is to reduce your monthly payment.
  • Loan term changes: If you need to lower your payment to make it more affordable, your lender may be willing to extend your repayment term. Your monthly payment will go down, and you’ll have additional time to repay the loan.
  • Loan structure changes: Some loans have an adjustable or variable interest rate. In these cases, your lender may be willing to modify your loan to a fixed-rate structure so your monthly payment won’t change over time.
  • Principal forbearance: In some instances, your lender may agree to allow you to repay some of the principal balance later. For example, it might add the principal payments you missed to the end of your loan. In rare cases, lenders may agree to write off this principal if you participate in a modified repayment plan for a certain period. You may be responsible for income taxes on any principal your lender forgives.

Loan modifications are usually only offered to borrowers who are past due on their payments and in immediate danger of foreclosure because of a financial hardship.

What is a mortgage refinance?

Refinancing occurs when you replace your existing mortgage with a new one. By refinancing your mortgage, you may be able to cash out some of your home’s equity or change the terms of your loan.

What a refinance can do for you

Refinancing your mortgage might be a good idea if you’re interested in:

  • Lowering your interest rate
  • Getting a fixed interest rate
  • Consolidating higher-interest-rate debt
  • Cashing out some of your equity
  • Paying your loan off faster
  • Extending your repayment terms

When is it best to use a loan modification?

It’s best to use a loan modification if you’re having trouble paying your existing mortgage and are in imminent danger of foreclosure.

If you have a financial hardship, reach out to your lender ASAP. The earlier you ask for assistance, the more help you may receive.

Some primary reasons for using a loan modification are:

  • You need a lower payment. If you can no longer afford your payment because of a financial hardship or interest rate adjustment, your lender may reduce your monthly payment by setting a lower fixed interest rate or extending the repayment term. You’ll need to show your lender you can afford the new payment over the long term before it approves a loan modification.
  • You need help catching up on your payments. If you’re behind because of temporary financial hardship like a job loss, your lender may be willing to reduce or pause your payments temporarily, move some of the past-due principal to the end of the loan or even forgive some of the principal if you follow through with the terms of the loan modification agreement.
  • Your loan is underwater, and you can’t qualify for a refinance. If your home is worth less money than you owe and you need to refinance it, you likely won’t qualify since most lenders won’t let you refinance for more than your home’s appraised value. You may be able to qualify for a streamlined modification to change your rate and terms without an appraisal.
  • You need to reduce the principal. If you can only afford the loan and avoid foreclosure by lowering your mortgage’s principal, you may want to see if your lender will approve a loan modification. If your lender wants to protect its interests by helping you avoid foreclosure, this may be a viable option. Remember that you may owe income taxes on any principal your lender agrees to forgive.

Unlike refinancing, loan modification is designed to help borrowers facing financial hardships. According to Joseph C. Smith II, managing director of Stretto Default Solutions, “Modifications should be considered with delinquent loans; the delinquent loan would be considered riskier and would have a higher rate if refinanced. The existing note is being rewritten with a change to rate, term, principal balance and possibly the borrowers (death and divorce).”

Ultimately, your lender must decide if its interests are best protected by modifying your loan rather than foreclosing on your home.

When is it best to refinance?

It’s best to refinance your mortgage if you want to get a different type of mortgage, get a lower interest rate, shorten or extend your repayment term or cash out some of your equity.

  • You want to change your mortgage type. If you have an adjustable-rate mortgage (ARM) and want to move to a fixed-rate mortgage, you can do so via a refinance. Locking in a fixed interest rate can help minimize stress because your monthly payment will never change, even when interest rates are rising.
  • You want a lower interest rate. Refinancing can be a way to get a lower interest rate. You might want a lower rate if you got your mortgage when rates were higher, or your credit has improved and you now qualify for a lower rate.
  • You want to change your repayment term. Refinancing can give you a shorter repayment term if you want to pay your loan off faster (e.g., 15 years instead of 30). Paying off your loan earlier may help you save money since you won’t be paying interest for as long. Alternatively, if you want a lower payment, you can seek a longer repayment term (e.g., 30 years instead of 15).
  • You want to cash out some of your home’s equity. Whether you’ve built up equity in your home from paying off your loan for many years, making improvements to your home or market appreciation, refinancing may allow you to cash out some of that equity. A cash-out refinance can be a good option if you want to keep making one payment (versus getting a second home equity loan), the interest rate on your existing loan is higher than market rates and you have at least 20% equity in your home.

Smith, from Stretto Default Solutions, advised that “a consumer should consider refinancing when they are current and/or anticipating a need to change the existing terms. Refinancing generally occurs when the borrower can lower their interest rate — suggested to be at least a 1% reduction — in order to lower the payment. The other main reason is to change the term of the loan.”

Remember, unlike with a loan modification, you don’t need to stay with your existing lender if you refinance your mortgage. Instead, you can shop for the best mortgage refinance company for your specific needs.

FAQ

Can you refinance if you did a loan modification?

When you can refinance after a loan modification or forbearance varies based on the type of loan you get, your lender and your loan modification agreement.

For conventional mortgages backed by Fannie Mae, you’re eligible for a refinance after you’ve made three payments on time if the hardship was not due to COVID-19. There is no refinance waiting period for loan modifications caused by COVID-19 financial hardships.

How does a loan modification affect a refinance?

If your credit was negatively affected by the situation that led to needing a loan modification (e.g., payment delinquency or bankruptcy), it might be harder to qualify for a refinance. Also, details about your loan modification may appear on your credit report, which could make it more difficult to qualify for a refinance.

Will a loan modification negatively impact my credit score?

A loan modification can negatively impact your credit score, particularly if your lender requires you to be past due before making a modification or reports the modification to the credit bureaus. However, the impact on your credit score will be less than if you continue to make late payments, the lender forecloses on your home or you file for bankruptcy.

Bottom line

Whether you need a loan modification or refinance depends on your financial circumstances. Loan modifications provide help for borrowers who are experiencing financial hardships and are in imminent danger of foreclosure. Refinancing allows borrowers to lower their rates, change repayment terms or cash out their home equity.

Regardless of whether a loan modification or refinance is right for your situation, carefully consider your options before making a decision. When in doubt, seek expert guidance.

ConsumerAffairs writers primarily rely on government data, industry experts and original research from other reputable publications to inform their work. To learn more about the content on our site, visit our FAQ page. Specific sources for this article include:
  1. Consumer Financial Protection Bureau, “What is a mortgage loan modification?” Accessed Nov. 18, 2022.
  2. Consumer Financial Protection Bureau, “If I can’t pay my mortgage loan, what are my options?” Accessed Nov. 18, 2022.
  3. Experian, “How Does Loan Forbearance Affect Credit?” Accessed Nov. 18, 2022.
  4. Experian, “How Will a Mortgage Loan Modification Affect My Credit Scores?” Accessed Nov. 18, 2022.
  5. Fannie Mae, “Fannie Mae Announces Flexibilities for Refinance and Home Purchase Eligibility.” Accessed Nov. 18, 2022.
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