Loan Modification Vs. Refinance: What’s Right For You?
Homeowners struggling to keep up with their monthly mortgage payments may have options to avoid defaulting or even foreclosure. Using either a loan modification or refinance can allow you to change your mortgage’s interest rate or term, leading to a more affordable monthly payment.
Let’s take a look at the main differences between a loan modification versus a refinance, including when you might use one or the other and how these options can help you if you’re able to take advantage of them.
Refinance Vs. Loan Modification: Key Differences
First, if you’re unfamiliar with loan modifications or refinancing, it’s important to learn the basics of both processes and what they entail. Below, you’ll find a general definition of each and insights into how they work.
What Is A Loan Modification And How Does It Work?
When you ask for a loan modification, you’re not asking to replace your existing mortgage with a new one. Instead, you’re adjusting the current loan’s rate, term or other details. Modifications may include extending your loan term, changing your interest rate or choosing a different type of loan, for instance, changing to a fixed-rate mortgage from an adjustable-rate mortgage.
A loan modification has the potential to negatively affect your credit score – but not as severely as defaulting on your mortgage or going into foreclosure. Always make sure you understand how a loan modification will affect your personal finances, monthly payment and mortgage both in the short-term and long-term before accepting any changes.
Mortgage Modification Requirements
It’s very important to note that a loan modification is not an option you can choose to pursue at any time. To qualify for one, you will need to go through the process of proving hardship to your lender. If you’re experiencing one of the following situations, you may qualify for a modification program:
- Unemployment
- Divorce
- Natural disaster
- Sudden death in the family
- A medical condition
Mortgage lenders have no obligation to accept your request, so this option is not generally a first choice of homeowners that believe they may be heading toward financial difficulty.
What Is A Refinance And How Does It Work?
Refinancing a mortgage means taking out a new loan to pay off your existing loan balance, essentially replacing it with a new mortgage. Ideally, you would refinance your current mortgage when interest rates are lower so that your new mortgage will come with a lower interest rate and more preferable terms than before.
If you have enough equity, you may even be able to refinance into a loan with no private mortgage insurance (PMI), which would also help lower your monthly payment. You can even refinance to a different type of mortgage if you think another loan type would work better for your situation.
Mortgage Refinance Requirements
Similar to getting your original mortgage, qualifying for a refinance means meeting your lender’s requirements. It’s also important to understand that each type of refinance requires a different minimum credit score, maximum loan-to-value (LTV) ratio and maximum debt-to-income (DTI) ratio:
- Conventional loans: Most borrowers need a minimum credit score of 620, an LTV between 75% – 95% and a DTI lower than 50% for a conventional rate-and-term refinance.
- FHA loans: For a Federal Housing Administration rate-and-term refinance, you’d need a minimum credit score of 580 and a maximum LTV of 80% – 97.75%. The maximum DTI ratio accepted will depend on the amount of equity you have in the home.
- VA loans: The Department of Veterans Affairs offers several types of refinance loans. For a rate-and-term refinance, you could most likely qualify with a 580 credit score and a DTI ratio of less than 60%. Some lenders may also allow an LTV as high as 100%.
While these are general guidelines, specific requirements can vary between lenders and geographical areas.
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Loan Modification Pros And Cons
A loan modification can benefit a struggling homeowner, but it isn’t without drawbacks. Take a look at the pros and cons of a loan modification:
Pros | Cons |
|---|---|
You can potentially lower your monthly payment and interest rate. | Your credit score will be impacted by a loan modification unless it’s related to a natural disaster. |
Loan modifications don’t have closing costs. | You must show evidence of financial hardship. |
A loan modification can help you avoid foreclosure. | Modifying a loan may require you to provide a lot of information to prove you qualify. |
Loan modifications can sometimes be faster than going through the refinancing process. | A loan modification can increase your rate and extend your loan term. |
Some lenders may also allow a principal forbearance during a loan modification. | Modifying a loan can also add escrow to your account – and you’re responsible for all fees incurred during delinquency. |
Refinancing Pros And Cons
Refinancing, too, can have benefits and drawbacks. Check out some of them below:
Pros | Cons |
|---|---|
You can potentially lower your monthly payment and get a new rate and better terms. | Good or excellent credit is usually required for a better rate. |
You can refinance through a different lender if they offer a better deal. | Refinancing can involve high closing costs. |
You can take cash out of your equity using a cash-out refinance. | You’re essentially restarting your loan repayment. |
You can potentially remove PMI. | Refinancing likely won’t be an option if you are behind on payments or your mortgage is underwater. |
Getting A Loan Modification Vs. Refinancing
The process required for a loan modification versus a refinance differs significantly. Take a look below at how borrowers can apply for each.
How To Apply For A Loan Modification
Being approved for a loan modification begins with providing your lender with information about your finances and proof that you’re facing financial hardship. Follow these steps when pursuing a loan modification:
- Contact your lender: Explain your financial situation to your lender and what caused it. Have your monthly expenses available so you can talk through your budget with your servicer. The sooner you contact your lender, the better.
- Provide proof of income: Your lender will require proof of your finances showing that you can’t currently afford your mortgage payments. Recent pay stubs, tax returns and bank statements are all accepted as proof of income.
- Create a financial hardship letter or fill out an application: Some lenders may ask for a written “hardship letter” explaining your situation and why you’re requesting a loan modification. Or, you may be asked to fill out an application.
- Review any modification offers: If your lender accepts your application, they may make you one or more offers for loan modification. You can look over the terms of the modification and then accept or reject them.
Bear in mind that your lender can outright deny your request for loan modification, so it’s not something you should consider your first or only option.
How To Refinance Your Mortgage
Refinancing follows a formula similar to the original mortgage process, so the steps of applying for a refinance should feel familiar to many homeowners. They are as follows:
- Choose a lender: You can work with your original lender or see if there’s a better offer elsewhere. Shop around and compare to make sure you land the best rates and terms.
- Submit an application: A refinance application will usually be simpler than the one you filled out when you were looking to buy your home.
- Lock in your rate: Many lenders give you the option to lock in your mortgage rate. This will keep your rate from being affected by market changes while you go through the underwriting process.
- Complete the underwriting process: Mortgage underwriters will evaluate your financial information to see if you qualify for a refinance. Your lender may also arrange an appraisal to ensure they’re not providing a loan that’s more than the home is worth.
- Close on your new loan: After the appraisal and underwriting are completed, you’ll receive your Closing Disclosure, which outlines the terms of your new loan and closing costs. Finally, you’ll attend the refinance closing and sign the papers for your new mortgage.
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When To Get A Mortgage Loan Modification Or Refinance
Whether you pursue a loan modification or refinance will largely depend on your financial situation and changes in the housing market. Let’s explore when it makes the most sense to go for a refinance or request a loan modification.
When A Loan Modification Makes Sense
Attempting to request a loan modification may make sense if you find yourself in any of the following scenarios:
- You’ve fallen behind on your payments. Lenders require you to be up to date with your monthly payments before they grant you a refinance. A loan modification, if you could get one, would make more sense in this scenario.
- You’ve been affected by a natural disaster. If you’ve been impacted by a natural disaster like a hurricane or earthquake or a unique emergency, a loan modification may also make sense.
When A Mortgage Refinance Makes Sense
It could be wise to consider refinancing your mortgage in the following instances:
- You’re not underwater on your loan but want to lower your payments. If you foresee financial difficulties on the horizon but haven’t missed any mortgage payments yet, you may have refinancing options to make your monthly payments more manageable.
- You have enough home equity and interest rates are trending downwards. A good amount of equity in your home – at least 20% for most loan types – is usually a requirement for refinancing. And, if interest rates are lower now than when you got the loan, you may be able to refinance to a lower rate to save money.
- You want to take out cash. A cash-out refinance allows you to convert part of your home’s equity into cash to pay for home improvements, upgrades or something else, while also refinancing your loan.
The Bottom Line
A loan modification and a refinance can both help you out if you’re struggling to make your mortgage payments, but one option may be better suited for your situation than the other. Modifying your loan adjusts your current loan so you can more easily afford the payments, while a refinance can grant you a whole new loan with different rates and terms. By reviewing your financial situation and the pros and cons, you can better decide which option would best suit your needs.
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