Loan Modification Vs. Refinance: Which Is Best For You?

You might want to refinance your loan if you’re having trouble making your mortgage payments or if you want to take advantage of a lower interest rate. However, you may also want to apply for a loan modification from your lender. Refinances and loan modifications both have their own benefits and drawbacks. It’s important to do your research before you decide.

Let’s go over some of the differences between refinances and loan modifications. We’ll also tell you how to apply for both.

A loan modification is a change to the original terms of your mortgage loan. Unlike a refinance, a loan modification doesn’t pay off your current mortgage and replace it with a new one. Instead, it directly changes the conditions of your loan.

It’s also important to know that modification programs may negatively impact your credit score. If you're current on your mortgage payments, it would be better to review your options and see if you can apply to refinance.

You can only get a loan modification through your current lender because they must approve the terms. Some of the things a modification may adjust include:

• Loan term changes: If you’re having trouble making your monthly payments, you may be able to modify your loan and extend your loan term. This gives you more time to repay your loan and reduces the amount you must pay every month.

• Interest rate reduction: If interest rates are lower now than when you locked into your mortgage loan, you might be able to modify your loan and get a lower rate if you don’t qualify for a refinance. This usually lowers your monthly payment.

• Loan structure changes: You may be able to modify your loan from an adjustable interest structure to a fixed-rate loan. This can be beneficial if you now live on a fixed income and you need a more predictable monthly payment.

• Principal forbearance: Your lender may agree to set some of your principal balance aside to be paid back later. This can help reduce payments and/or make your mortgage more manageable. However, these modifications are rare. You can usually only get a principal forbearance if no other possible solution will help you avoid foreclosure.

Lenders have no obligation to accept your request for a modification or to renegotiate your principal. This means that getting a modification is usually more difficult than refinancing. You'll need to show evidence of hardship. Every lender and investor in the loan (such as Fannie Mae, Freddie Mac, FHA, etc.) has their own standards when it comes to who qualifies for a modification and what types of modifications they offer.

You may receive offers from settlement companies to help you get a loan modification if you’re behind on your mortgage. These companies negotiate with your lender on your behalf and can make getting a loan modification easier. However, it's important to note that these companies often serve as middlemen, charging you for something that your loan servicer provides for free.

If you do decide to work with one of these companies, do your research on the provider before you agree to any contract. The last thing you need is a high-fee contract with a settlement company if you’re already behind on your mortgage payments. If what's being offered seems too good to be true, chances are it probably is.

It makes sense to seek a loan modification before a refinance in some instances. Let’s look at some of those times.

• Your loan is underwater. An underwater mortgage is when you owe more money on your home than your property will appraise for. Your loan can go underwater if you miss payments early in your term or if you live in an area where property values are falling. Some types of loans (such as FHA Streamline) allow refinances for underwater loans, but require that you have at least six consecutive on-time payments to qualify.

• You need a principal reduction. You cannot reduce your mortgage principal with a refinance. A loan modification may be able to help if you’re likely to go into foreclosure.

• You’re behind on your monthly payments. A lender won’t allow you to refinance unless you’re current on your monthly payments. Seek a modification if you can’t catch up on your monthly payments before you apply.

Every loan servicer has their own standards for loan modification. Most require you to apply with financial documentation that proves you need the modification. Some of these documents include:

• Proof of income: Your lender needs to know that you don’t have enough income to cover your current mortgage. Proof of income can include a salary agreement or contract from your employer that states your hourly rate or annual income.

• Your most recent tax return: Your lender will likely need your entire tax return when you request a loan

• Bank statements: Your lender might ask for bank statements to confirm your assets.

• A hardship statement: A hardship letter tells your lender why you can no longer make your monthly payments or pay for your entire loan balance. You may also want to include supplementary documentation along with your letter to further illustrate your situation.

Contact your lender and ask how to apply if you think you qualify for a loan modification. Keep in mind that your lender may refuse your request. You may still qualify for a refinance if that happens to you.

You replace your existing loan with a new mortgage when you refinance. This allows you to change the terms of your loan. You can also use your equity to take cash out of your home. You might want to refinance to:

• Lengthen your mortgage term. You lower your monthly mortgage payment when you refinance to a longer mortgage term. This can help you avoid financial problems if your income is now lower than when you got your loan.

• Shorten your term. You can also shorten your mortgage term with a refinance. Your monthly payment increases when you shorten your term. However, you own your home sooner and save money by reducing your interest paid.

• Take a lower interest rate. A refinance can help you lock in a lower rate if interest rates are lower now than when you got your loan.

• Change your loan type. It might be beneficial to refinance to a new loan type if you have enough equity in your home to qualify. No worries, we’ll help you figure that out when you’re ready to refinance to a different loan type than you currently have (from an ARM to a fixed-rate loan, for example).

• Take a cash-out refinance. A cash-out refinance allows you to draw money from your home equity to cover outside expenses. You take on a higher-balance loan and in exchange, your lender gives you the difference in cash.

Let’s take a look at a couple of times when it makes sense to take a refinance over a modification.

• You’re not underwater on your loan. Though there are special refinance programs that can help you adjust the terms of an underwater loan, refinancing is much easier when you have equity.
• You want to take cash out of your home equity. You can take cash out of your home equity if you meet equity standards. Borrowing from your home equity isn’t possible with a loan modification.

You’ll choose a lender, submit an application and offer your personal financial documentation for underwriting. Your lender will usually give you the option to lock in your interest rate as well. This protects you against market interest rate movements.

After you lock in your rate, your lender underwrites your loan to make sure you qualify to refinance. With most types of refinances, you must get an appraisal before you can close on your new loan. The appraisal ensures you and the lender that you’re not borrowing more money than your home is worth.

Once the appraisal and underwriting processes are complete, your lender will give you a Closing Disclosure. The Closing Disclosure tells you more about the terms of your loan and your closing costs. You’ll then attend a closing meeting and sign on your new loan.

When you take a loan modification, you change the terms of your loan directly through your lender. Most lenders agree to modifications only if you’re at immediate risk of foreclosure. A loan modification can also help you change the terms of your loan if your home loan is underwater.

On the other hand, a refinance replaces your existing mortgage with a new loan. When you refinance, you can change your loan’s term, your interest rate and even your loan type. You can also take cash out of your equity with a cash-out refinance.

Ready to refinance? Create your Rocket Mortgage^® account today to begin crafting the perfect refinancing solution for you.