Loan Modification vs. Refinance

A low interest rate environment coupled with the effects of the volatile rate environment in recent years has caused Americans who own homes to consider changing the terms of their mortgages. Their existing loans may have carried higher interest rates, which in turn leads to higher monthly payments. The result is that a number of Americans are looking for a mortgage loan that suits their situation better. Refinancing replaces a mortgage loan with a new one, while a loan modification changes the terms of an existing loan. Either of these options could be appropriate for a number of people’s specific situations.

Consider working with a financial advisor as you weigh the merits of refinancing and loan modification on your long-term financial plan.

What Is a Loan Modification?

A loan modification is a change in the terms of your mortgage. It is not a new loan replacing the older mortgage loan. You work with the lender already holding your loan if you want to modify it. You may get your mortgage extended by several years, which would reduce your monthly payment. If your loan has a high interest rate, perhaps your lender can lower your interest rates to a more competitive level, which would also reduce your monthly payment. If you have an adjustable rate mortgage (ARM), it might be preferable to change to a fixed-rate loan, especially if you are now older and need a predictable monthly payment. It is possible to receive forbearance at least.

A loan modification is generally used for homeowners with two different needs. They may need loan restructuring because they are underwater on their mortgage. Being underwater on a mortgage simply means that you owe more on the mortgage than your house is worth. The second reason a homeowner may need loan modification is if they are significantly behind on their payments.

Loan modification has pros and cons.  The pros of modifying a mortgage loan include possibly being able to secure better terms for your loan either through an interest rate reduction or an extension of the term of your mortgage. Another pro is that you may be able to avoid foreclosure on your home. Finally, unlike refinancing, you do not have to pay closing costs with a loan modification. The cons of modifying a mortgage loan include having your credit score possibly affected by modifying your mortgage loan. Also, if you miss a payment after you modify your loan, you are in more danger of foreclosure.

When Is Refinancing a Mortgage Appropriate?

When you refinance your mortgage, you apply for a new loan, perhaps with a different lender. Refinancing is usually the first thing homeowners think about when they want to change the terms of their loans with loan modification being a less popular option. Sometimes it’s also an option for people whose mortgages are underwater.

Refinancing a mortgage loan is usually only for people with equity in their homes, a reasonably high credit score, a debt-to-income ratio less than a certain level and adequate income to make the payments on the new loan. Usually, an appraisal of your home will be necessary. Not only your current credit score, but also your entire credit history, will undergo scrutiny.

Your total debt-to-income ratio is an important variable in the refinance decision. For a conventional mortgage loan, it is usually around 36%, including your housing costs. The ratio is higher for government loans, such as Federal Housing Administration (FHA) loans, but a higher income can mitigate that.

Refinancing your home loan can mean you either want to raise or lower your payments. If you want to lengthen the term of your mortgage because your income isn’t as high as when you took out the loan, that is an option. If this should be the case, apply for a refinance before you miss any mortgage payments, or you may need to get a loan modification. You can also shorten the term of your loan to pay off your home quicker and save money on the interest charges.

You may also want to refinance to lower your interest rate. If interest rates have dropped since you bought your home, it may be a good time to refinance. Another reason for refinancing a home is to change your loan type altogether. If you have an adjustable-rate mortgage (ARM), you may want to change to a fixed-rate loan so your payments will be predictable.

You may be able to get a cash-out refinance. If you have sufficient equity in your home, you may be able to use the extra cash for home improvement, debt consolidation or some other reason.

Refinancing a loan is often more expensive than loan modification because you usually have to pay closing costs of several thousand dollars. A loan modification is often free.

SmartAsset’s mortgage rates page can give you an overview of what the current rate environment looks like.

Loan Modification vs. Refinance

Loan modification and refinancing a home are best for two different types of homeowners. A loan modification is for homeowners who can prove financial hardship to their lending institution. They also must prove that they can afford the payments on the modified loan.

A refinance is appropriate for homeowners in good financial standing and who want more preferable terms, based on their goals, for their home mortgages. Generally, those homeowners who have their loans modified could not qualify for a refinance.

Bottom Line

If you need to change the terms of your mortgage loan, sit down with a loan officer, go through all the facts and crunch all the numbers. Should your closing costs be too high on the refinance, it may take years to recover them. In that situation, don’t refinance right before you move.

If you get a loan modification, your credit score could take a hit. That’s because they are oftentimes a settlement, as in a type of bankruptcy. Get all the information you can before refinancing your home or modifying your current home loan. Then, make an informed decision.

Tips on Mortgages

• In difficult financial times, it can be confusing to know what to do about your home mortgage if you feel like you can do better. A financial advisor can offer valuable assistance as you seek to clarify your choices. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
• SmartAsset’s mortgage calculator can help you decide what you can afford for either a loan modification or refinance.
• Do you want to know how much your closing costs will be if you refinance? Take a look at SmartAsset’s closing costs calculator for help.

Photo credit: ©iStock.com/JLco – Julia Amaral, ©iStock.com/Olivier Le Moal, ©iStock.com/xferrantraite