Loan modifications are most common for secured loans, such as mortgages, but you may also be able to modify other types of loans. That could include personal loans or student loans.
A loan modification can relieve some of the financial pressure you feel by lowering your monthly payments and stopping collection activity.
But loan modifications are not foolproof. They could increase the cost of your loan and add derogatory remarks to your credit report.
That doesn’t mean you should avoid a loan modification. But before you jump at the chance, consider all the angles.
What Is a Loan Modification?
It’s exactly what the name implies, says Jeff Broeker, executive director at Chase Home Lending.
If it’s a mortgage loan modification, he says, “It’s modifying the terms of the loan to reduce the payment so the customer can afford the home and stay in the home.”
No matter the loan type, the idea is that if you’re struggling, tweaking the terms can help. Generally, loan modifications are limited to situations where you can’t afford full payments and your credit is too poor to refinance the loan.
A loan modification is not for someone who simply wants a better interest rate. In that case, a refinance is a better option.
A borrower who is going through a temporary or sudden setback can request mortgage assistance, Broeker says. In some cases, a lower payment could help you get through a rough patch and avoid foreclosure.
Borrowers with loans owned or guaranteed by Fannie Mae or Freddie Mac may be eligible for the Flex Modification program, which targets a 20% payment reduction. Lenders could also have their own loan modification programs.
Loan modification can change one or more of the terms of your loan to provide relief if you are financially stressed by the coronavirus pandemic or otherwise. Modifications can include:
- Reducing your interest rate
- Changing a variable interest rate to a fixed one
- Extending the term length
The extended loan term compensates the lender for the reduced interest rate or payment. So your 30-year mortgage might become a 40-year one, Broeker says.
But in exchange you’ll get:
A reduced payment. If you can reduce your monthly payment, it could be just the relief you need to pull through tough times.
A chance to keep your home. Banks prefer to avoid foreclosure because it’s an expensive process. The best outcome for the homeowner and the bank is a loan modification to make continued payments possible.
What Are the Drawbacks of a Loan Modification?
A loan modification can be an expensive lifeline. Keep these drawbacks in mind before you commit:
Your loan will likely cost you more in the long run. Adding years to your loan might mean paying more in interest over the life of the loan.
Your loan modification may be stressful. “The loan modification process can be a bit time-consuming and frustrating in terms of gathering all you’ll need to apply,” says Leslie Tayne, debt resolution attorney and founder and managing director of Tayne Law Group.
You’ll need to gather documents, such as recent pay stubs, bank statements and tax returns, and complete an income vs. expenses worksheet, Tayne says. You’ll also have to write a hardship statement explaining your need for a loan modification.
Most of this information is fairly straightforward, but getting it together can be tedious. You may also have a trial period before the modification is approved, Broeker says.
“Chase doesn’t let anyone get into a modification until they’ve proven for three months that they can make that newly lowered payment,” he says.
Be sure to ask questions about the terms and fine print because all lenders are different.
You loan modification might not be approved. With loan modifications, you have to be struggling – but not too much. Your application really hinges on your hardship situation.
“You will need to prove your ability to pay the loan,” Tayne says. “This allows the lender to know that this should be a one-time difficulty and that you’ll be able to make some form of a monthly payment going forward.”
If you truly can’t afford the property, the bank may reject the loan modification request. “In those cases, we work with the customers to coach them on selling the home in a short sale,” Broeker says.
Do Loan Modifications Affect Your Credit?
If you’re thinking about a loan modification, chances are your credit has already taken a hit. “Most customers in the process are already delinquent,” Broeker says.
When you proceed with a loan modification, a comment code will appear on your credit report that says something like “paying by modified terms.”
But getting back on track with payments could have enough of a positive effect on your credit over time to make up for this derogatory remark.
If you’re still unsure whether a loan modification is a good idea and hesitate to extend your loan term, remember that you can refinance later, when you’re on better financial footing.
“I don’t think loan modification fits everybody,” Broeker says, “but it’s the single best tool we have from a loss mitigation perspective to keep people in their homes.”