Homeowners who are behind on their mortgage payments can choose two common ways to find financial relief: a home loan modification or mortgage refinancing, each with benefits and drawbacks.
To shed some light on the issue, let’s take a look at loan modifications vs. refinancing to see if either is right for your unique financial needs.
Related: What is a non-recourse loan?
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What Is a Loan Modification?
A home loan modification is a change in the way the home mortgage loan is structured, primarily to provide some financial relief for struggling homeowners.
Unlike refinancing a mortgage, which pays off the current home loan and replaces it with a new one, a loan modification changes the terms and conditions of the current home loan.
Those changing loan terms may include the following — if they’re approved by the mortgage lender.
- The loan repayment timetable. A loan modification may extend the term of the loan, allowing the borrower to have more time to pay off the loan.
- A lower interest rate. Loan modifications may also allow borrowers to lower the interest rates on an existing mortgage loan. A lower interest rate can reduce a homeowner’s monthly mortgage payment.
- Switch from an adjustable-rate loan to a fixed-rate loan. Some borrowers may have adjustable-rate mortgages that allow for variable interest rates over the term of the loan. A fixed-rate loan offers consistent monthly payments over the life of the loan.
A loan modification may not be as easy to qualify for as refinancing, as mortgage lenders are under no obligation to change the terms and conditions of a home loan, even if the borrower is behind on payments. Documents requested by the lender must show financial hardship, and might include hardship letters, bank statements, tax returns, proof of income, or others.
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What Is Refinancing a Loan?
A home loan refinancing doesn’t just restructure the terms of a mortgage loan, it replaces the current loan with a new loan that typically has a different interest rate, a longer or shorter term, or both.
Refinancing may be an option to take advantage of lower interest rates, but there are plenty of other reasons to refinance a home loan.
- Extend the payment terms. Having a longer period of time to pay off a loan generally lowers the monthly payment and can relieve some of the borrower’s financial stress. It may be an option that keeps the home out of foreclosure.
- Shorten the loan repayment time. Some homeowners may opt to refinance their mortgage loan into a shorter repayment term (e.g., from a 30-year to a 15-year home loan). While that may increase the monthly loan payments depending on the interest rate on the new loan, it will likely reduce the overall cost of the home loan, as the homeowner will pay down the entire mortgage loan faster.
- Cash-out loan refinancing. Mortgage refinancing also allows homeowners to borrow more than the balance owed on the current loan if there is ample home equity and can be a viable alternative to a personal loan, as well.
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Refinance vs Loan Modification: Pros and Cons
Reasons for a mortgage loan modification or refinance can be an individual as each homeowner.
Loan modification is typically sought by borrowers who are unable to make payments and may be trying to keep their home from being foreclosed on.
Refinancing a mortgage is generally more of a choice rather than a last resort before foreclosure — lenders generally require a loan to be in good standing to qualify for refinancing.
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Benefits of Refinancing a Loan
Mortgage borrowers whose financial foundation is strong are likely to be able to qualify for a new loan with favorable terms. A few different reasons a loan refinance might be an advantage to a borrower are:
- Lower interest rate. A creditworthy borrower may be able to qualify for interest rates lower than their current loan, which could mean a savings over the life of the loan.
- Change the term of the loan. A shorter loan term can mean higher monthly payments but is likely to be an overall saving. A longer loan term generally means lower monthly payments but may cost more over the life of the loan if the interest rate is not lower than the current mortgage.
- Cash-out refinance. Refinancing a mortgage, which is a loan secured by the borrower’s home, can be one way to take advantage of home equity. The new loan is for a greater amount than what is owed, the old loan is paid off, and the excess cash can be used for things like home renovations or for debt consolidation.
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Drawbacks of Refinancing a Loan
Considering the drawbacks of refinancing, in addition to the benefits, can help borrowers make financial decisions that work in their best interest.
- Processing time. Refinancing is getting a brand-new loan, and all the typical paperwork has to be completed, which can take between 30 and 45 days. The lender may require an appraisal of your home, even if it’s the same lender your current mortgage is with. Lenders will also require income and employment verification, as well as checking the applicant’s credit report for debt information.
- Qualifying. It’s likely easier for an applicant with strong credit to be approved for a mortgage loan refinance, rather than one who is less creditworthy. Lenders will check credit reports when assessing a mortgage loan application. Small credit score changes can make a big difference in the interest rate offered and, in turn, the overall cost of the loan.
- Closing Costs. Depending on how much time is left on the loan, refinancing may not be a good option. It’s important to compare the overall cost of the two loans — the current mortgage and the potential new loan, taking into account any closing costs that a lender may charge, whether those costs are paid in cash or rolled into the new mortgage loan and how quickly they can be recouped.
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Benefits of Loan Modification
Loan modification may be considered as an option to stave off foreclosure and might be seen as a negative, but there are benefits that can go along with it, too.
- Faster processing time. Since loan modification must be completed with the same lender — vs. refinancing, which is a completely new loan and can be with the lender of the applicant’s choice — the time from start to finish is likely to be shorter.
- Potential increase in home equity. Negotiating a reduction of the loan principal could effectively increase the equity the borrower has in their home. The home’s value remains the same, but the amount owed is less.
- Changes to the loan’s terms. It may be possible to increase the length of the loan, making the monthly payments smaller. Or if the original interest rate was variable, it could be possible to switch to a fixed rate, which could equal a savings over the life of the loan.
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Drawbacks of Loan Modification
Since loan modification is generally an effort to prevent foreclosure on the borrower’s home, there are some drawbacks to be aware of.
- Potentially negative effect on credit. A loan modification on a credit report is a negative entry and could lower the borrower’s credit score. However, having a foreclosure — or even missed payments — can be more detrimental to a person’s overall creditworthiness.
- Cash out is not an option. Unlike refinancing, a loan modification cannot be used to access home equity and get cash in a lump sum. If monthly payments are lower after modification, though, the borrower may have more funds to pay other expenses each month.
- Hardship requirement. It’s typically necessary to prove financial hardship to qualify for loan modification. Lenders may want to see that your extenuating financial circumstances are involuntary and that you’ve made an effort to address them, or have a plan to do so, before considering loan modification.
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Is It Better to Refinance or Get a Loan Modification?
“Better” is relative. Considering a refinance or loan modification, and which may be the better option, depends on the borrower’s financial situation and reasoning.
Borrowers who have solid credit and are current on their mortgage loans may choose refinancing instead of loan modification. The main reason for strong borrowers to consider a new loan might be to take advantage of lower interest rates or to tap into their home equity.
Borrowers who may not have strong credit may also be having trouble making their mortgage loan payments and could be at risk of foreclosure. In this scenario, refinancing may not even be an option because the borrower may not be able to qualify for a new loan.
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Alternatives to Refinancing and Loan Modification
For borrowers looking for ways to save some money on their loans, it doesn’t have to mean loan modification vs. refinancing.
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1. Mortgage Forbearance
For borrowers facing short-term financial challenges, a mortgage forbearance may be an option to consider.
Lenders may grant a term of forbearance — typically three to six months, with the possibility of extending the term — during which the borrower doesn’t make loan payments or makes reduced payments. The lender also agrees not to pursue foreclosure.
As with a loan modification, proof of hardship is likely to be required, and lenders may consider things like divorce, job loss, natural disasters, costs associated with medical emergencies, or others.
During a period of forbearance, interest will continue to accrue, and the borrower will still be responsible for expenses such as homeowners insurance and property taxes.
At the end of the forbearance period, the borrower may have to repay any missed payments in addition to accrued interest. Some lenders may work with the borrower to set up a repayment plan rather than requiring one lump repayment.
Recommended: What is Mortgage Forbearance?
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2. Mortgage Recasting
If a borrower is in a financial position to make a lump-sum payment towards the mortgage loan principal, mortgage recasting may be another alternative to either loan modification or refinance.
A lender may charge a nominal fee to recast a mortgage and may also have a minimum amount they’ll accept. An average minimum is $5,000.
After the lump-sum payment is made, the lender will recast, or re-amortized, your remaining loan repayment schedule. Since the principal amount is smaller after the lump-sum payment is made, each monthly payment for the remaining life of the loan will be smaller.
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3. Making Extra Principal Payments
Using extra money in each month’s budget to make additional principal payments on a mortgage loan can be an effective way to reduce loan costs, as long as the lender does not charge a prepayment penalty.
Making extra principal payments can have a greater financial effect if those payments are made earlier in the loan term rather than later. An amortized loan consists of two amounts: principal and interest, paid in equal monthly installments.
Monthly interest amounts are largest at the beginning of the loan term and decrease with each installment. Conversely, principal amounts are smallest at the beginning of the loan and increase with each installment.
If a borrower makes an extra payment specifically toward the principal, the amount owed is lowered incrementally, potentially saving both interest costs and time to pay the loan in full if this strategy is used consistently.
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What are the disadvantages of loan modification?
Lenders are not required to grant a loan modification, so other options may need to be pursued.
Is a loan modification bad for your credit?
Loan modification can have a negative effect on the borrower’s credit report, but having missed payments or a foreclosure on a credit report can have a more detrimental effect.
Is it better to refinance or get a loan modification?
Choosing between a loan refinance or loan modification depends mostly on the borrower’s financial situation. A loan modification is likely to be an effort to stave off foreclosure, where a loan refinance is more likely to be a conscious choice made by the borrower to save money or to tap into home equity.
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Considering loan modification vs. refinancing is a process that depends on multiple factors, not the least of which is the financial situation of the borrower.
Borrowers who are facing financial challenges and who may be at risk of foreclosure may want to look into loan modification, which could be easier to qualify for than loan refinancing. But for a borrower who is interested in looking for a lower interest rate — or just general savings on their loan — or want to tap into their home equity, refinancing may be a more likely option.
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