Mortgage Loan Refinancing vs. Modification: How to Choose

If a significant life change has made it harder for you to pay your mortgage, you may be able to reduce your mortgage payments through refinancing or loan modification.

Although loan modification and loan refinancing both offer pathways to reduce monthly payments or adjust loan terms, they cater to different financial situations and come with distinct benefits and drawbacks. Let’s look at the differences so you can make an informed decision tailored to your needs.

What is mortgage loan refinancing?

Refinancing replaces your existing mortgage with a new loan, usually with different terms. Homeowners use their new loan to pay off the balance of their current mortgage and make monthly payments per the terms of the new mortgage.

Refinancing can come in various forms based on your specific needs. This includes: a cash-out refinance, short refinance, streamline refinance, rate-and-term refinance, or no-closing costs refinance. For homeowners struggling with monthly payments, a rate-and-term refinance or short refinance may be the best option. Borrowers should reach out to a home lending advisor to determine which options are available to them.

Rate-and-term refinance: A rate-and-term refinance allows you to swap your mortgage for a new one with better terms. Most homeowners choose this option when current refinance rates are lower than the rate on their current mortgage. A lower interest rate can mean monthly payments are reduced, and you pay less interest over the life of the mortgage. If interest rates are on the rise, homeowners with an adjustable-rate mortgage can refinance to lock in a lower rate with a fixed-rate mortgage.

A rate-and-term refinance may also offer the chance to extend your loan term so you can lower your monthly payment. While this type of refinance offers many benefits, you’ll need a good credit score to qualify. You’ll also need to cover closing costs, so this may not be the best option if you don’t have funds available.

Short refinance: A short refinance is when a lender agrees to refinance a loan for less than the borrower’s existing mortgage balance. The lender issues you a new loan with a reduced balance and essentially forgives the difference.
Lenders usually agree to a short refinance to help a borrower avoid foreclosure when it will minimize the lender’s loss and save time. Foreclosure proceedings can be time-consuming. The lender may not receive any income from the house during the foreclosure process while still having to pay to maintain it. Moreover, a foreclosure sale may not generate enough funds to cover the cost of the mortgage, so the lender may face a bigger loss.

Pros

Explore the pros of refinancing below:

• Lower interest rates: Refinancing can help homeowners secure a lower interest rate, reducing both monthly payments and total interest paid over the loan term.
• Avoid foreclosure: The key benefit of a short refinance is that it lets you keep your home and avoid foreclosure.
• Consolidate debt: If you use a refinance to pay off your current debts, it may help you consolidate those debts into a single, manageable loan.
• Changing the type of mortgage: A refinance may let you replace your adjustable-rate mortgage with a fixed-rate mortgage and vice-versa.

Cons

The drawbacks of a refinance are as follows:

• Credit requirements: Refinancing typically requires good credit and stable income, making it less accessible for those with poor credit.
• Closing costs: A new mortgage means a new set of closing costs similar to the original mortgage, including appraisal, application fees, and other expenses.
• Potential credit damage and tax implications: A short refinance may negatively impact your credit. Additionally, the IRS may treat your forgiven debt as income, so you may need to report it and pay tax on the amount.

How do you refinance your mortgage?

Refinancing your mortgage involves a process similar to obtaining your original mortgage. Here’s a step-by-step overview:

• Compare offers from different lenders to find the best terms and rates for your refinance.
• Submit a refinance application, providing documentation such as income statements and tax returns.
• Allow your lender to order an appraisal from a qualified 3rd party to assess the value of your home.
• If approved, you’ll close on the new loan, paying any associated closing costs.

What is a mortgage loan modification?

A loan modification changes the terms of the mortgage you already have, making it more affordable. A loan modification may grant you a better interest rate or term length or even forbearance of a loan’s principal amount. You can only get a loan modification through your current lender, and they must approve the new terms. Here are some of the modifications that lenders may offer.

• Interest rate reduction: Your lender may be willing to lower your rate, especially if rates have dropped since you got your mortgage.
• Principal forbearance: Your lender may temporarily reduce your principal or set aside an amount to be repaid later as a balloon payment.
• Loan term extension: A lender may let you extend your loan term so your monthly payments are lower.
• Interest structure: Your lender may give you the option to convert an adjustable-rate mortgage to a fixed-rate mortgage. This is beneficial if rising interest rates have affected your monthly payments

Pros

The benefits of loan modification are as follows:

• Manageable payments: A loan modification can be an effective way to lower your monthly payments.
• Flexible requirements: Lenders may offer more flexible creditworthiness criteria compared to refinancing, focusing more on your current hardship.
• No closing costs: Unlike a refinance, you won’t pay closing costs or go through the mortgage application process all over again.

Cons

Here are some cons of loan modification:

• Hardship requirement: Typically, loan modifications are only available during demonstrable financial hardship, such as job loss, divorce, or natural disasters. A modification won’t be available to everyone who wants a lower rate.
• Potential rejection: Lenders are not obligated to approve modification requests, and your application may be denied.
• Refinancing delay: Opting for a loan modification may delay your ability to refinance in the future, as it might affect your creditworthiness.

How do you obtain a mortgage loan modification?

Different lenders may have different eligibility criteria for their loan modification program. Some lenders may need borrowers to have experienced a qualifying life event (such as job loss, long-term illness, or loss of a spouse). You’ll need to talk to your lender to find out if you’re eligible for a loan modification.

To secure a loan modification, follow these steps:

• Contact your lender: Reach out to your mortgage servicer to discuss your financial hardship and request a modification.
• Gather documentation: Provide necessary documentation such as income statements, recent tax returns, proof of hardship (e.g., job loss, medical bills), and an explanation of your financial situation.
• Submit your application: Depending on your lender, you may need to submit a formal application for loan modification. Once approved, you can start making your new monthly payments.

It’s important to note that loan modifications are not one-size-fits-all. Different lenders may propose different terms based on their policies.

Choosing between loan modification and refinancing

The right mortgage strategy will ultimately depend on your financial circumstances and needs. Conventional refinancing is suitable for homeowners with stable finances and good credit looking to take advantage of lower interest rates, reduce monthly payments, or tap into home equity. Traditional refinancing can be pursued during both stable and challenging financial times, provided you meet the lender’s credit and income requirements. Short refinancing, on the other hand, is great for homeowners dealing with financial instability as it lets you keep your home and offers a long-term solution.

Loan modification is designed for homeowners experiencing financial hardship who need immediate relief from high monthly payments. It’s a viable option when struggling with job loss, medical emergencies, or other significant financial disruptions.
While a short refinance may be a better option than a loan modification, the decision may come down to availability. It’s not always easy to find lenders offering short refinancing, so loan modification may be easier to attain.