Loan modifications are a long-term financial relief option for homeowners who can’t make their mortgage payments. If approved by your lender, this option can help you avoid foreclosure by lowering your interest rate or changing the structure of your overall loan.

What is a loan modification?

A loan modification involves changing your existing mortgage so it’s easier for you to keep up with your payments. These changes can include a new interest rate or a different repayment schedule. It likely won’t reduce the amount you owe on the balance of your mortgage.

Lenders allow borrowers to modify loans because default and foreclosure are more costly to their business. In other words, they don’t want the house, but they do want the loan repaid. A modification helps accomplish both goals.

“A loan modification entails changes made to the terms of the loan itself — usually reducing the interest rate or extending the length of the loan,” says Rick Sharga, president and CEO of CJ Patrick Company, a real estate consulting firm in Trabuco Canyon, California. “This allows you to lower your monthly mortgage payment and, ultimately, prevent default and foreclosure.”

How does a mortgage modification work?

The goal of modifying a mortgage is to reduce your monthly payments to an affordable level, helping you stay up to date on the loan and in your home. The modification options might include one or a combination of these:

• Cut the interest rate: With a lower rate, you’ll have lower monthly mortgage payments and save on interest in the long run.
• Extend the repayment period: Lengthening the loan term lowers your monthly mortgage payments. (A longer repayment period increases the amount of interest that accrues, however, adding to the loan’s overall cost.)
• Reduce the principal: In some cases, the lender might forgive some of the loan balance in order to lower your monthly payments. Keep in mind: The IRS treats forgiven debt as income, so you’ll need to report it on your tax return.
• Convert to a fixed-rate mortgage from an adjustable rate: The interest rate on an adjustable-rate mortgage moves up and down. If it goes up, your monthly payments might no longer fit into your budget. Swapping to a fixed-rate gives you much more financial stability.

When obtaining a loan modification, confirm with your lender or servicer whether the modification is temporary or permanent, and what your new monthly payment will be. Always read the fine print, and ask questions if you’re unsure about the long-term implications of a modification.

Compare the total payments under your original loan to the total payments under the modified loan. What you don’t want is a temporary reduction only to find the reduced amount added back on to your mortgage balance and then have to pay interest on the larger balance.

Also, avoid any modifications that are interest-only and adjust to a higher rate, add unnecessary costs to your loan in the form of penalties, fees or processing charges or result in a large balloon payment due after a certain period, says Sharga.

These types of modifications might only make sense if you plan to hang onto the home just long enough to sell it, in order to salvage your equity and credit.

How to qualify for a mortgage modification

A lender won’t approve a mortgage modification just because you ask nicely. Usually, you’ll have to meet at least three requirements:

• Be at least one month behind on your loan, or about to miss a payment
• Have a significant financial hardship such as:
  • Long-term illness or disability
  • Death of an income-providing family member
  • Sudden hikes in housing costs like property tax
  • Divorce
  • Natural disaster
• Live in the home as your primary residence

Loan modification programs

If you need mortgage relief, consider the following mortgage modification programs:

• Conventional loan modification – For conventional mortgages owned by Fannie or Freddie, you can pursue the Flex Modification program, which can reduce monthly payments by up to 20 percent, extend the loan term up to 40 years and potentially lower the interest rate.
• FHA loan modification – There are a few options for an FHA loan modification, including an interest-free loan for up to 30 percent of your balance. The government is also weighing the option for a 40-year loan extension.
• VA loan modification – If you have a VA loan, you can roll the missed payments back into the loan balance and work with your lender to come up with a new, more manageable repayment schedule. Another option might be extending the loan term.
• USDA loan modification – With a USDA loan, you can modify your mortgage with an extended term of up to 40 years, reduce the interest rate and receive a “mortgage recovery advance,” a one-time payment to bring the loan current.

Alternatives to mortgage modification

• Forbearance: This is a short-term solution in which the lender agrees to suspend or reduce your monthly mortgage payments for up to one year. Keep in mind that interest will continue to accrue during the forbearance period. Once the forbearance ends, you’ll be put on a repayment plan.
• Refinance: If prevailing interest rates have fallen since you first got your loan and you have strong enough credit and income to qualify for a new mortgage, and can afford the closing costs, refinancing can help you lower your monthly payment permanently either by reducing the loan’s rate or extending its repayment term. (However, if you’re at the point of considering a modification, you likely don’t have the income to qualify for a refinance.)
• Short sale: Short sales involve selling your home when the balance of your mortgage is more than the home’s value (an underwater mortgage). Your lender will need to approve this type of sale, and it can have tax implications.
• Deed in lieu of foreclosure: This is a last-resort option where you give up the deed to your home in exchange for the lender releasing you from the loan payments. This allows you to avoid the severe credit damage of having a foreclosure on your record, but means you lose the home.

How to apply for a loan modification

If you’re applying for loan modification, follow these steps:

1. Gather information about your financial situation. Get financial documents and a letter explaining your hardship ready to show your lender.
2. Plan out your case. Before contacting your lender or servicer, consider whether your circumstances require a long-term or short-term solution. Be prepared to make your case.
3. Contact your servicer. Contact your lender or servicer and ask for a loan modification. If you’re denied, you may be able to ask for a second review if you applied at least three months before your home’s foreclosure sale.

Is a loan modification right for me?

A mortgage loan modification is a solution for borrowers facing long-term financial hardship, and it can offer permanent relief. If you’re struggling to make your mortgage payments, work with your lender or servicer to see if a loan modification is the best strategy for you.

If you don’t foresee changes to your financial situation, loan modification might be preferable to shorter-term fixes that could leave you with a larger hole to climb out of.