Loan Modification vs Refinance: How to Decide Which Option is Best For You

If you’re struggling to make your mortgage payments or want to take advantage of lower interest rates, you may be wondering whether a loan modification or refinance is the better option. Both have their pros and cons so it’s important to understand how they work before deciding which is right for your situation.

In this comprehensive guide, I’ll explain the key differences between loan modifications and refinancing, when each option makes the most sense, and how to go about getting approved for each

What is a Loan Modification?

A loan modification allows you to change the terms of your existing mortgage loan with your current lender. This differs from a refinance, where you take out an entirely new loan to pay off your current one.

With a modification, your loan balance stays the same but the interest rate, repayment term, or other conditions may change. Common types of modifications include

• Lowering the interest rate – This reduces your monthly payments.

• Extending the repayment term – This lowers your payments by spreading them over more time.

• Adding missed payments to the loan balance – This helps bring you current if you’ve fallen behind.

• Reducing the principal balance – Only offered in extreme hardship cases to help avoid foreclosure.

Loan modifications are only available through your current lender. You’ll need to prove financial hardship to qualify, such as reduced income or high medical bills. Not all lenders offer modifications, and investor guidelines may limit their options.

Modifications won’t improve your credit score. They may even hurt it temporarily by adding late payments to your balance or marking your loan as “restructured.” But they can help you avoid foreclosure if you truly need payment relief.

When Does a Loan Modification Make Sense?

There are a few situations where a loan modification may be your best option:

• You can’t refinance due to low home equity – If your home value has dropped so that you owe more than it’s worth, you may be “underwater” on your mortgage. Most lenders won’t let you refinance without equity, but a modification may be possible.

• You need to add missed payments to your loan balance – If you can’t catch up on late payments prior to refinancing, a modification allows you to roll them into your balance. This brings your loan current.

• You require a principal reduction – Lenders will sometimes reduce loan balances for borrowers facing hardship. But this type of modification is very rare.

• You have an adjustable-rate mortgage – Modifications allow you to convert an ARM loan to a fixed rate, which can provide payment stability.

• You need immediate payment relief – Applying for a modification is often faster than refinancing, so it may help if you need urgent payment assistance.

The key is understanding whether a modification can provide the specific relief you need right now. If not, refinancing may be the better path forward.

How Do I Apply for a Loan Modification?

Here are some tips for pursuing a mortgage modification with your lender:

• Contact your servicer – This is the company you make payments to. Ask what modification programs they offer and the application process.

• Gather documentation – You’ll need to submit documents proving financial hardship. This may include bank statements, pay stubs, medical bills, and a hardship letter.

• Complete the application – Follow all instructions closely. Any missing details can delay or derail your request. Expect to provide personal and financial information.

• Follow up persistently – Don’t wait around for your servicer to contact you. Call frequently to verify they have everything needed to review your application.

• Consider hiring assistance – Mortgage modification companies can negotiate with your lender on your behalf for a fee. Carefully vet any firm before hiring them.

• Be prepared for denial – Lenders reject many modification requests. If you’re denied but still struggling, ask about alternatives like repayment plans or forbearance.

Persistence and detailed documentation are key when seeking a mortgage modification. If you don’t qualify, refinancing may still be an option.

What is Refinancing Your Mortgage?

Refinancing involves taking out a new home loan to replace your current one. It allows you to change the interest rate, term length, loan type, and more. Reasons to refinance include:

• Lowering your interest rate – You can reduce monthly payments by refinancing at a lower rate. This saves money over the loan’s life.

• Shortening your loan term – You can pay off your mortgage faster by refinancing to a shorter term. You’ll pay less interest but have higher monthly payments.

• Switching from an ARM to a fixed rate – Refinancing lets you lock into a stable rate rather than face fluctuating ARM payments.

• Tapping home equity – Cash-out refinancing lets you take equity out as cash. This can consolidate debt or fund home improvements.

• Ditching private mortgage insurance (PMI) – Refinancing may allow you to cancel PMI if you’ve reached 20% home equity.

To qualify for a refinance, you’ll need good credit and equity in your home. Refinancing carries closing costs, but over time you may still come out ahead thanks to lower payments or interest savings.

When Does Refinancing Make More Sense?

Here are some instances when refinancing tends to be the better mortgage adjustment option:

• You want to tap your home equity – Only a cash-out refinance allows you to access your equity. Loan modifications don’t.

• You have sufficient equity – Refinancing requires that you have 20-25% equity at a minimum. If you’re underwater, modification may be your only choice.

• Your credit score has improved – Modifications don’t help your credit, but refinancing can lock in better loan terms thanks to credit improvements.

• Interest rates have dropped – To score a lower rate through refinancing, you usually need a 0.5-1% drop compared to your current one.

• You’re selling soon – Modifying an existing mortgage you’ll pay off when selling won’t help much. Refinancing could save interest until you sell.

• You need a lower monthly payment – Refinancing may secure a lower payment than modification if you don’t qualify for principal or rate reductions.

Look at both options objectively to see which provides the relief you need at an acceptable cost. Refinancing works better for many borrowers who have the time and equity.

How Do I Refinance My Mortgage?

If you determine refinancing is your best course of action, here’s an overview of the process:

• Check your home equity – Request an appraisal to ensure you have adequate equity to qualify based on the type of refinance you want.

• Improve your credit – Good credit means better refinance rates. Pay down balances and correct errors to boost your score.

• Research lenders – Compare multiple mortgage refinance offers to find the best rate and terms. Look for minimal fees.

• Complete your application – Provide financial documents like paystubs, tax returns, and bank statements for underwriting. Authorize the lender to pull your credit.

• Get an appraisal – The lender needs this to verify your home value and finalize the loan terms you qualify for.

• Lock your rate – Once approved, lock in an interest rate to protect against increases. There is usually a fee.

• Review closing docs – Scrutinize the Closing Disclosure for final loan details like your new payment. Ensure there are no surprises.

• Close your refinance – Sign documents to finalize your new loan. The lender pays off your old mortgage and records the new lien.

Move quickly if refinancing, as rates can change daily. It takes about 30-45 days to close once you apply. Avoid surprises by communicating clearly with your lender throughout the process.

Making the Right Choice For Your Situation

As you can see, loan modifications and mortgage refinancing share some similarities but differ in key ways. When making your decision, consider factors like:

• Your current financial hardship
• How much equity you have in your home
• Whether you need payment relief immediately
• Your credit score and history
• Interest rate trends
• How long you plan to stay in your home

Ideally, discuss both options with your lender or mortgage professional. They can help weigh the pros and cons for your specific mortgage and financial position.

Being well-informed is critical when determining if loan modification or refinancing best fits your needs and long-term financial goals. Carefully compare the costs, benefits, and drawbacks before making a commitment.