What Is a Loan Modification and How Does It Work?
With millions of Americans unemployed due to the global pandemic, many Americans are falling behind on their mortgage payments and in need of financial relief. While most mortgage companies are modifying loans through a short-term forbearance, many borrowers won’t necessarily be in a better financial situation in a few months.
Fortunately, temporary forbearance is not the only option available to distressed borrowers. For those who were already financially strapped before the impact of COVID-19 or those who need more long-term financial relief, permanent loan modifications may be worth considering. It’s important to understand what happens when you get a loan modification before going forth with the process.
What is a loan modification?
A loan modification is a permanent change to the repayment schedule on a loan. While loan modification is possible with any type of loan, it is most common with secured loans, especially mortgages. The loan modification process is generally designed to keep borrowers from defaulting on the loan entirely by providing a manageable way to get back on a regular payment schedule. Many types of borrowers are eligible for a loan modification, but these changes are most commonly granted to individuals who are in some kind of financial crisis.
When should I use a loan modification?
If you recognize an impending financial crisis, it is in your best interest to proactively avoid default on your loans by communicating with your lender. For mortgages, a loan modification can be especially helpful to borrowers in the following situations:
- You have an underwater mortgage – This occurs when you owe more on your mortgage than the house is worth. For borrowers in this situation, selling the house isn’t an option because they would likely have to pay a large lump sum to close on the loan.
- You’re ineligible for refinancing – Refinancing a loan can also be costly, but it doesn’t leave a negative mark on your credit history. However, borrowers must have a decent credit history and a stable source of verifiable income to be eligible for refinancing, which isn’t possible for many homeowners.
- You’re behind on monthly payments – With every missed payment, it becomes harder to catch up. Each missed payment also brings you closer to foreclosure, so loan modification can be a viable way to stop the missed payment cycle and get back on track with your loan.
What are the benefits of a loan modification?
Although loan modification shouldn’t be taken lightly, there can be some discernable benefits to working with your lender to permanently modify the terms of your loan agreement. If you are experiencing financial hardship, modifying your loan can provide the financial breathing room you need to keep up with your other monthly bills. Loan modification generally reduces your monthly payment amount, making it easier to make future payments on time, thus preventing further damage to your credit. Most importantly, modifying your loan can be a proactive way to get ahead of your financial troubles and avoid an extreme financial crisis, such as a foreclosure.
What are the downsides?
Before securing a mortgage modification, borrowers should also carefully weigh the downsides. Many lenders may charge high loan modification fees to process the change, and some modification programs can result in increased interest charges and other payments over the life of the loan. A home loan modification may be a costly process, but it can also damage your credit. For borrowers who are otherwise in good standing, accepting a loan modification can add a negative mark to your credit history and make the lender less likely to help you if another financial crisis arises.
Types of loan modifications
Mortgage lenders generally lose more money on a foreclosure than a loan modification, so most lenders offer at least some type of modification program. Every lender has different offerings, but most mortgage loan modifications fall into one of these categories:
- Fixed-rate loan: For borrowers who are currently in a variable rate loan that has ballooned, converting to a lower fixed-rate loan can provide some needed financial relief.
- Interest rate decrease: Some lenders may be willing to negotiate lower interest rates without forcing borrowers through a refinance process. Even a fraction of a percent can make a significant difference over a 30-year mortgage, but be sure to ask how long the modification will last. Sometimes the rate decrease is only temporary.
- Term extension: If your original loan term was less than 30 years, your lender might be willing to stretch the loan term to a 30-year loan, effectively reducing your monthly payments. Be careful, however, as the longer-term will add a significant amount of interest over the life of the loan.
- Payment postponement: For borrowers who are 30 days or more past due, some lenders are willing to postpone those payments, then tack the payments on to the end of the loan and extend the loan term by a few months.
- Principal reduction: This modification is the least likely and the hardest to obtain, but when the only other option seems to be foreclosure, some lenders are willing to reduce the amount of loan principal remaining. Since this amounts to financial “forgiveness,” the amount reduced could count as income on the following year’s tax return, so be aware of any tax implications under this modification program.
If your lender doesn’t seem willing to work with you on a loan modification, you may be eligible for assistance through one of these government modification programs:
- Flex Modification: Under the Federal Housing Finance Agency’s direction, the program offers loan modification options to borrowers with a Fannie Mae or Freddie Mac mortgage loan. Those who qualify can benefit from monthly payment reductions (up to 20%) and a reduction of the principal loan balance by up to 30%.
- FHA-HAMP: Although the original version of the Home Affordable Modification Program (HAMP) is no longer available, the Federal Housing Administration (FHA) offers its version of HAMP to borrowers with FHA loans. Qualified borrowers can receive both an interest rate reduction and a reduction of the principal loan balance by up to 30%.
- Department of Veterans Affairs (VA) loan modification: For borrowers with a VA mortgage loan, missed monthly payments and associated fees can be added into the principal loan balance. Then the VA arranges a new mortgage payment schedule to get you back on track.
- USDA loan modification: Once a USDA loan becomes 30 days or more past due, borrowers are eligible for loan modification programs, which involve making a permanent change to lower the interest rate, monthly payment amount, or both.
Does loan modification affect your credit?
Loan modification can affect your credit history, so be sure to ask your lender how accepting a loan modification will affect you before moving forward with the change. Since a loan modification is essentially admitting that you can’t fulfill your original commitment, most lenders will add a derogatory mark to your credit report. However, any negative change in your credit history as a result of loan modification will have less of an impact on your credit score than missed payments or foreclosure.