Loan Modification Vs. Refinance | Bankrate

Thomas Barwick/Getty Images

A loan modification and a mortgage refinance generally address the same desire: to lower the monthly payment on your home. However, the two options are intended for homeowners in very different situations. Here’s a closer look at when you’d apply for a loan modification and when you’d apply for a refinance.

Loan modification vs. refinance

When you refinance your mortgage, you swap it for a new one, often with a new interest rate or loan term. Homeowners typically refinance to lower their monthly mortgage payments, pay their home off faster or tap into home equity. To qualify, you’ll need to prove that you can afford the new mortgage. Unlike a loan modification, a refinance comes with hefty closing costs.

A refinance is something you choose to do — if you don’t refi, you might miss out on savings, but you won’t lose your house. A loan modification, on the other hand, is a loss mitigation option if you’re struggling to make mortgage payments. Without a loan modification, you risk going into default and losing your home to foreclosure.

To qualify for a loan modification, you’ll need to be behind on your payments or about to miss a payment, and you’ll need to document an economic hardship. If you qualify, your lender may reduce your interest rate, extend your loan term, change your loan type or a combination of the three — all with the goal of reducing your payments. You’ll typically pay a small administration fee to modify your loan.

When loan modifications make sense

If you’re struggling to make your mortgage payments, a loan modification could make sense — especially if any of the following also apply:

• You have poor credit. Modifications are attractive to struggling borrowers because they don’t require a high credit score. This option is designed to keep borrowers out of foreclosure.
• You’re unable to provide proof of income. Unlike refinances, loan modifications don’t require proof of income. You’ll need to provide documentation of a financial hardship, however.
• You need immediate relief. Usually, loan modifications provide immediate mortgage relief, whereas refinancing can take 30 days or more. Borrowers can’t access cash via loan modifications the way you can with a cash-out refinance, but a loan modification doesn’t prevent homeowners from selling their homes.

Before applying for a loan modification, consider the pros and cons:

Pros of loan modification

• Lower monthly payments: By extending the loan term or lowering your interest rate, you could owe lower monthly mortgage payments.
• Avoid default and foreclosure: Agreeing to loan modification can help you avoid losing your house from missing mortgage payments.
• Keep the same loan with new terms: With modification, you keep the loan rather than swapping it out for a new one, the way you do in a refinance. This helps you avoid paying closing costs for initiating a new loan.

Cons of loan modification

• Must show hardship: Lenders will only explore this option with you if you can show proof of financial hardship, such as job loss or divorce.
• Your credit score might take a hit: Lenders might not offer loan modification until borrowers have missed payments, something that lowers your credit score.
• Negotiating with lenders can be a cumbersome process: Lenders aren’t required to accept your loan modification application. Be ready for some potentially time-intensive discussions before you find a solution that works for you and your lender.
• Waiting period to refinance: Some lenders require you to wait for a certain period of time after a loan modification before you can refinance.

When refinancing makes sense

If you’re able to afford your current loan, but hoping to accomplish one of the following goals, refinancing could make sense:

• You want a lower interest rate. The classic reason to refi is to lower your mortgage interest rate. However, because refis have closing costs, it may take awhile to realize your savings. Be sure to calculate your break-even point — the amount of time you’ll need to make up the closing costs through lower monthly payments — before you commit.
• You’re renovating your house. If it’s time to update your kitchen, upgrade your bathrooms or otherwise modernize your house, 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 the renovations will add to the resale value of your home.
• You want to get rid of FHA mortgage insurance. Borrowers with Federal Housing Administration (FHA) loans can be especially good candidates for refinancing. That’s because FHA loans often require steep mortgage insurance premiums for the life of the loan. If you have at least 20 percent equity in your home, you could refinance to a conventional loan and avoid paying for mortgage insurance.

Before you refinance, evaluate the pros and cons:

Pros of refinancing

• Lower interest rate: This is the most common reason people refinance.
• You can pull cash out: If you choose a cash-out refinance, you can turn some of your home equity into cash and use it however you want.
• You can switch terms: You might refi into a loan with a shorter term so you can pay down your mortgage faster. Or you might refinance an adjustable-rate loan to a fixed-rate one to avoid paying more if rates climb.

Cons of refinancing

• You’ll need solid credit and income: The underwriting process for a refinance is not unlike the one you went through to get your first mortgage. Lenders want to see you’re in good financial standing before issuing you a new loan.
• Closing costs are steep: Expect to pay thousands of dollars to refinance your mortgage.
• You could reset the clock on your debt: When you refi, you’ll have the option to choose a new loan term — but that could make your loan more expensive. For example, if you’re five years into a 30-year mortgage, refinancing to a new 30-year loan could lower your monthly payments, but it also means paying even more in interest over time, even if you qualify for a lower rate.

How to modify your loan

Each lender has its own rules and requirements for loan modifications. Here are the general steps you’ll need to follow to modify your loan:

1. Contact your loan servicer: A representative can verify your eligibility for loan modification and explain the steps involved. Remember that your loan servicer may not be the company that originally issued your loan. You can find the name of your servicer on your mortgage statements or by searching here.
2. Gather your documentation: Most loan servicers require you to provide documentation of a hardship when applying for loan modification. You will likely need a hardship letter, bank statements, tax returns and proof of income.
3. Submit an application: Once you’ve collected your documents, you can submit your loan modification application.
4. Accept or deny the offer: Your loan servicer will review your application. You may receive a rejection, but if your request is approved, you’ll receive a loan modification offer. Make sure you understand how modification will change your monthly payments and the total cost of your loan before accepting.
5. Start making your new payments: It’s important to make your payments on time to avoid penalties and damage to your credit score.

How to refinance your loan

Refinancing your loan is similar to the process of getting your original mortgage:

1. Contact multiple lenders: Comparing three or more offers can help you get the best refinance loan for your situation.
2. Gather your documentation: Once you’ve picked a lender, you’ll have to provide the same documentation you submitted when applying for your original loan: usually, bank statements, pay stubs and tax returns.
3. Submit an application: The lender will review your application, verify your documents and run a credit check.
4. Get an appraisal: As part of the loan underwriting process, you may need to get — and pay for — a new appraisal on your home.
5. Close on the new loan: Once the underwriting process is complete, you can close on the new loan. The time to close depends on a variety of factors, but it can take up to two months.