When loan modifications make sense

If you have not been able to stay current on your mortgage payments, a loan modification could make sense. Mortgage forbearance can offer generous terms to homeowners who are out of work. However, when those forbearance periods end, lenders expect homeowners to resume making payments.

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, 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.

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.

Pros and cons of loan modification

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 up-to-date on your mortgage payments, refinancing might make sense.

One significant difference between a loan modification and a refinance 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.

Here are some reasons it can make sense to refinance:

You could get a lower interest rate. The classic reason to refi is to lower your mortgage interest rate. However, 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 out
• You 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.