Refinance vs Loan Modification: Which Option is Best for You?

As a homeowner, keeping up with mortgage payments can be challenging, especially when financial hardship strikes If you find yourself struggling to make monthly payments, you essentially have two options – refinancing your mortgage or modifying your existing loan terms. But how do you know which route is better for your situation? Here’s a comprehensive look at refinancing versus loan modification to help you make the right choice

What is Refinancing?

Refinancing simply means replacing your current mortgage with a new loan often with better terms. The most common goal of refinancing is to secure a lower interest rate on your home loan which translates to lower monthly payments.

Other reasons homeowners choose to refinance include

• Shortening the loan repayment term – For example, switching from a 30-year to 15-year mortgage. This increases monthly payments but allows you to pay off the loan much faster.

• Tapping home equity – Cash-out refinancing converts equity into cash you can use for other purposes like home improvements.

• Switching loan types – Such as from an adjustable-rate mortgage (ARM) to a fixed-rate loan to lock in a low rate.

The refinancing process is similar to obtaining a new mortgage. You’ll submit a loan application and supporting documents so the lender can re-evaluate your finances. Closing costs, including fees for appraisals and title insurance, generally range from 2% to 5% of the loan amount.

When Does Refinancing Make Sense?

Refinancing tends to work best when:

• Interest rates have dropped since you obtained your current mortgage. The bigger the rate gap, the more you’ll save each month and over the loan term.

• You have built up significant home equity. This allows more flexibility to take cash out or qualify for better refinance rates.

• Your credit score has improved. The higher your score, the more likely you’ll qualify for lower interest rates.

• You can recoup closing costs relatively quickly. Ideally within 1-3 years through the monthly savings from lower interest rates or payments.

• You plan to stay in the home long enough to reap the rewards. At least 5-7 years for most refinances to break even.

What is Loan Modification?

Also referred to as a “loan mod”, this process alters the terms of your existing mortgage to make it more affordable. Loan modifications are reserved for homeowners facing financial hardships that make it difficult to keep up with payments.

Some potential changes in a loan modification include:

• Extending the repayment term – For example, from a 30-year to a 40-year mortgage. This lowers the monthly payment by spreading it over more time.

• Lowering the interest rate – Even a small rate reduction can mean significant savings each month.

• Switching loan types – Such as from a fixed-rate to adjustable-rate mortgage.

• Adding missed payments to the loan balance – Referred to as capitalization.

• Reducing the principal amount owed.

Modifying a loan is much less involved than refinancing. There are no closing costs, and you keep your original mortgage – it’s just adjusted. Loan modifications may carry small administrative fees.

When Does Loan Modification Make Sense?

This option works best when:

• You’re facing financial hardship due to events like job loss, reduced income, divorce, medical problems, etc.

• You’ve missed several mortgage payments or are on the verge of defaulting on your loan.

• You don’t have the time or money for a lengthy refinance process. Loan mods provide faster relief.

• You have limited options due to credit damage or insufficient income/home equity.

• You want to avoid foreclosure and remain in your home if possible.

Key Differences Between Refinancing and Loan Modification

Here’s a quick rundown of how the two options differ:

Refinancing

• Initiated voluntarily
• For homeowners in good financial standing
• Involves new loan/lender
• Requires income/credit qualification
• Closing costs apply
• Interest rate/terms depend on current market rates
• Permanent solution

Loan Modification

• For homeowners unable to make payments
• Retain existing mortgage
• Requires hardship eligibility
• No closing costs
• Adjusts rate/terms of current loan
• Provides temporary payment relief
• Can impact credit scores

Which Option is Right For You?

Deciding between refinancing and loan modification depends largely on your financial situation and goals.

Here are some key questions to ask yourself:

• Why do I need payment relief? Is it temporary hardship or a long-term issue like mortgage affordability? This can dictate whether a loan mod or complete refinance makes more sense.

• How is my credit score? The minimum score for refinancing is around 620, but 720+ unlocks better rates. If your score is damaged, a mod may be the only option.

• What is my income situation? Refinancing requires full income documentation and enough steady monthly earnings to support the new mortgage payment.

• How much equity do I have? You typically need at least 20% equity to refinance. Insufficient equity makes it harder to qualify and limits refinancing flexibility.

• Can I afford closing costs? Closing costs can be rolled into refinance loan amount, but that increases your principal. Loan mods have minimal fees.

• How long will I stay in the home? You need 5-7 years of lower payments to break even on refi closing costs. Less time favors a loan mod.

• What are my rate/term options? Only refinancing allows customizing loan terms like switching from 30-year to 15-year mortgage. Mods alter existing terms only.

Carefully considering these factors will steer you towards the best solution – refinance or loan modification – for your unique situation. If you’re unsure, talk to a financial advisor or mortgage professional for guidance. While both options offer mortgage relief, choosing correctly can save you money and prevent future headaches.